Form 10-K - Hexion Specialty Chemicals, Inc.
Table of Contents

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-K

 


 

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2005

 

Commission File Number 1-71

 


 

HEXION SPECIALTY CHEMICALS, INC.

(Exact name of registrant as specified in its charter)

 


 

New Jersey   13-0511250
(State of incorporation)   (I.R.S. Employer Identification No.)
180 East Broad St., Columbus, OH 43215   614-225-4000
(Address of principal executive offices)   (Registrant’s telephone number)

 

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

 

Title of each class   Name of each exchange on which registered
None   None

 

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

NONE

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes  ¨    No  x.

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes  x    No  ¨.

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days. Yes  ¨    No  x.

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer ¨

   Accelerated filer ¨    Non-accelerated filer x

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes   ¨    No  x.

 

At June 30, 2005, the aggregate market value of voting and non-voting common equity of the Registrant held by non-affiliates was zero.

 

Number of shares of common stock, par value $0.01 per share, outstanding as of the close of business on March 1, 2006: 82,629,906

 

Documents incorporated by reference. None

 



Table of Contents

HEXION SPECIALTY CHEMICALS, INC.

 

INDEX

 

PART I

    

Item 1 – Business

   3

Item 1A – Risk Factors

   20

Item 1B – Unresolved Staff Comments

   35

Item 2 – Properties

   35

Item 3 – Legal Proceedings

   37

Item 4 – Submission of Matters to a Vote of Security Holders

   39

PART II

    

Item 5 – Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

   39

Item 6 – Selected Financial Data

   39

Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations

   40

Item 7A – Quantitative and Qualitative Disclosures About Market Risk

   69

Item 8 – Financial Statements and Supplementary Data

   70

Hexion Specialty Chemicals, Inc. Consolidated Financial Statements

    

Consolidated Statements of Operations, years ended December 31, 2005, 2004 and 2003

   71

Consolidated Balance Sheets, December 31, 2005 and 2004

   72

Consolidated Statements of Cash Flows, years ended December 31, 2005, 2004 and 2003

   74

Consolidated Statements of Common Stock and Other Shareholder’s (Deficit) Equity, years ended December 31, 2005, 2004 and 2003

   75

Notes to Consolidated Financial Statements

   76

Reports of Independent Registered Public Accounting Firms

   131

Item 9 – Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

   134

Item 9A – Controls and Procedures

   134

Item 9B – Other Information

   134

PART III

    

Item 10 – Directors and Executive Officers of the Registrant

   134

Item 11 – Executive Compensation

   137

Item 12 – Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

   144

Item 13 – Certain Relationships and Related Transactions

   145

Item 14 – Principal Accountant Fees and Services

   148

PART IV

    

Item 15 – Exhibits and Financial Statement Schedules

   149

Signatures

   159

 

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PART I

 

ITEM 1. BUSINESS

 

(Dollars in millions, except per share data)

 

Overview

 

Hexion Specialty Chemicals, Inc. (which may be referred to as “we,” “us,” “our,” “Hexion” or the “Company”) is the world’s largest producer of thermosetting resins, or thermosets. Thermosets are a critical ingredient for virtually all paints, coatings, glues and other adhesives produced for consumer or industrial uses. We are focused on providing a broad array of thermosets and associated technologies, with leading market positions in all key markets served. Our breadth of related products provides us with significant advantages across our operations, technologies and commercial service organizations, while our scale provides us with significant efficiencies in our fixed and variable cost structure allowing us to compete effectively throughout the value chain. In areas where it is advantageous, we are able to internally produce strategic raw materials, providing us with a lower cost operating structure and security of supply. Our value-added, technical service-oriented business model enables us to effectively participate in high-end specialty markets, while our scale enables us to extract value from higher volume applications.

 

Thermosets are developed to meet the performance characteristics required for each specific end use product. The type of thermoset used and how it is formulated, applied and cured determine the key attributes such as durability, gloss, heat resistance, adhesion or strength of the final product. Hexion has the broadest range of thermoset resin technologies, with world class research, applications development and technical service capabilities. Our thermosets are sold under a variety of well-recognized brand names including BORDEN® (phenolic and amino resins), EPIKOTE® (epoxy resins), EPIKURE® (epoxy curatives), BAKELITE (phenolic and epoxy resins), LAWTER (inks) and CARDURA® (high-end automotive coatings). The total global thermoset resins market is approximately $34 billion in annual sales and includes products such as polyurethanes, urea-formaldehyde, phenol-formaldehyde, unsaturated polyesters, epoxies and melamine-formaldehyde. The key product areas of the global thermoset resins market upon which we focus and in which we have leading market positions is approximately $19 billion in annual sales, which excludes polyurethanes, unsaturated polyesters and furans/other.

 

Our products are used in thousands of applications and are sold into diverse markets, such as forest products, architectural and industrial paints, packaging, consumer products and automotive coatings, as well as higher growth markets, such as composites, UV cured coatings and electrical laminates. We have a history of product innovation and success in introducing new products to new markets. Our product innovation is evidenced by more than 1,000 patents, a majority of which relate to the devolvement of new products and processes for manufacturing. More specifically, in 2003, we developed and began marketing XRT®, a patent pending family of proppants made for the oil field products end-market, which generated approximately $30 million in net sales in 2005. In 2004, we developed and began conducting customer trials with Archemis, a resin used to formulate quick-dry alkyd paint. We are currently developing a family of customized resins tailored for the high-end lamination market.

 

Our organizational structure is based on the products we offer and the markets we serve. During the fourth quarter of 2005, we changed our reportable segments to better reflect the stage of the transition from the previous organization of our pre-merger companies to our organizational structure during the latter half of 2005. The transition provides greater alignment with the respective operating divisions and reporting segments. At December 31, 2005, our organizational structure consists of four operating divisions that are directly aligned with our reportable segments: Epoxy and Phenolic Resins, Formaldehyde and Forest Products Resins, Coatings and Inks, and Performance Products. We began implementing additional refinements to our operating divisions in 2006 to more closely link similar products, minimize divisional boundaries and improve our ability to serve common customers from pre-merger legacy company relationships which may result in additional refinements to our reporting segments.

 

As of December 31, 2005, we had 86 production sites globally, and produce many of our key products locally in North America, Latin America, Europe and Asia. Through our worldwide network of strategically located production facilities, we serve more than 10,000 customers in over 100 countries. We believe our global scale provides us with significant advantages over many of our competitors. In areas where it is advantageous, we are able to internally produce strategic raw materials, providing us a lower cost operating structure and

 

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security of supply. In other areas, where we can capitalize on our technical know-how and market presence to capture additional value, we are integrated downstream into product formulations. Our position in certain additives, complementary materials and services further enables us to leverage our core thermoset technologies and provide customers a broad range of product solutions. As a result of our focus on innovation and the high level of technical service that results from our “Total Systems Approach,” we have cultivated long-standing customer relationships. Our global customers include leading companies in their respective industries, such as 3M, Ainsworth, Ashland Chemical, BASF, Bayer, DuPont, GE, Halliburton, Honeywell, Huntsman, Louisiana Pacific, Owens Corning, PPG Industries, Sumitomo, Sun Chemicals, Valspar and Weyerhaeuser.

 

Industry

 

The thermoset resins industry is an approximately $34 billion market in annual sales. Thermoset resins include materials such as phenolic resins, epoxy resins, polyester resins, acrylic resins, alkyd resins and urethane resins. Thermoset resins are used for a wide variety of applications due to their superior adhesion and bonding properties, as well as their heat resistance, protective and aesthetic characteristics, compared to other materials. The key product areas of the global thermoset resins market upon which we focus and in which we have leading market positions have an estimated $19 billion in annual sales. The thermoset resin market has grown at an estimated annual rate of over 4% by volume during the past five years. We expect that certain segments of the thermoset resin industry, including composites and UV resins, will grow at substantially faster rates.

 

Thermosets are sold into the global coatings, composites and adhesives markets, which have combined annual sales of over $100 billion. Thermoset resins are generally considered specialty chemical products because they are principally sold on the basis of performance, technical support, product innovation and customer service. Although the thermoset resins market has undergone consolidation in recent years, the thermoset resins market remains fragmented with many small and medium sized companies providing a relatively high level of customization and service to the end markets and with any small non-core divisions of large chemical conglomerates. The principal factors contributing to success in the specialty chemicals market are (1) consistent delivery of high-quality products, (2) favorable process economics, (3) the ability to provide value to customers through both product attributes and strong technical service and (4) a presence in large and growing markets. We believe Hexion is the third largest North American based specialty chemicals company.

 

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Formation and History of Hexion

 

Hexion was formed on May 31, 2005 upon the combination of three Apollo Management, L.P. (“Apollo”) controlled companies (the “Combinations”): Resolution Performance Products, LLC (“Resolution Performance”), Borden Chemical, Inc. (“Borden Chemical”) and Resolution Specialty Materials, Inc. (“Resolution Specialty Inc.”). Apollo acquired Resolution Performance on November 14, 2000, formed Resolution Specialty Inc. and purchased the Specialty Resins and Monomers and Ink business of Eastman Chemical Company (“Eastman”) on August 2, 2004 through a subsidiary, Resolution Specialty Materials, LLC (“Resolution Specialty”), and acquired Borden Chemical on August 12, 2004. Coincident with the Combinations, Borden Chemical changed its name to Hexion Specialty Chemicals, Inc., and BHI Acquisition LLC, Borden Chemical’s parent, changed its name to Hexion LLC.

 

The Borden Transaction - On August 12, 2004, an affiliate of Apollo acquired all of the outstanding capital stock of Borden Chemical (the “Borden Acquisition”). The Borden Acquisition, the related offering of second-priority senior secured floating rate notes (the “Original Floating Rate Notes”) and 9% second-priority senior secured notes (the “Fixed Rate Notes”) and the related transactions are collectively referred to as the “Borden Transaction.” The issuance of the Original Floating Rate Notes and Fixed Rate Notes is discussed in the Liquidity and Capital Resources section of Management’s Discussion and Analysis of Financial Condition and Results of Operations (Item 7).

 

The Resolution Performance Transaction - On November 14, 2000, Resolution Performance Holdings LLC, an affiliate of Apollo, acquired control of Resolution Performance in a recapitalization transaction (the “Resolution Performance Transaction”). Prior to the recapitalization, Resolution Performance was a wholly owned subsidiary of the Royal Dutch/Shell Group of Companies (“Shell”).

 

The Resolution Specialty Transaction - On August 2, 2004, Resolution Specialty, an affiliate of Apollo, acquired the resins, inks and monomers division (the “Resolution Specialty Acquisition”) of Eastman Chemical Company (“Eastman”). The Resolution Specialty Acquisition and the related transactions are collectively referred to as the “Resolution Specialty Transaction.”

 

The Bakelite Transaction - On April 29, 2005, a subsidiary of Borden Chemical acquired Bakelite Aktiengesellschaft (the “Bakelite Acquisition”). Upon the consummation of the Bakelite Acquisition, Bakelite Aktiengesellschaft (“Bakelite”) became an indirect, wholly owned subsidiary of Hexion Specialty Chemicals Canada, Inc. (“Hexion Canada”). The Bakelite Acquisition was financed through a combination of available cash and borrowings under a bridge loan facility, which was refinanced with the proceeds of our second-priority senior secured floating rate notes due 2010 issued on May 20, 2005 (the “New Floating Rate Notes”) and borrowings under our senior secured credit facilities (collectively the “Bakelite Financing”). The Bakelite Acquisition, the repayment or assumption of certain of Bakelite’s debt in connection therewith and the Bakelite Financing are collectively referred to as the “Bakelite Transaction.” The financing arrangements related to the Bakelite Transaction are discussed in the Liquidity and Capital Resources section of Management’s Discussion and Analysis of Financial Condition and Results of Operations (Item 7).

 

On April 25, 2005, the Company filed a registration statement, which is not yet effective, with the SEC for a proposed initial public offering (“IPO”) of its common stock. We have subsequently filed six amendments to our registration statement from May 2, 2005 through November 21, 2005.

 

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We have begun and will continue to integrate the four predecessor companies including considering opportunities to consolidate our manufacturing plants, leverage our raw material purchasing power, cross-sell to our broader customer base and implement programs to continue to lower our operating and overhead expenses. We have also consolidated the management teams and centralized corporate functions of the four companies under the leadership of the current Hexion management team.

 

Business Realignment and Corporate Reorganization. The Company has undertaken numerous plant consolidations and other business realignment initiatives. These initiatives are designed to improve efficiency and to focus resources on our core strengths. The associated business realignment charges consist primarily of employee severance, plant consolidation and related environmental remediation costs and asset impairment expense. Following is a brief overview of our significant business realignment activities since 2001.

 

In 2001, Borden Chemical completed a significant capital restructuring to eliminate future required annual preferred dividend payments and recorded $126 million of business realignment and impairment charges related primarily to the closures of its melamine crystal business, which we refer to as Melamine, and two forest products plants in the United States, realignment of its workforce organization, reorganization of its corporate headquarters and the discontinuation of a plant construction project. The largest component of the 2001 charge is a $98 million impairment of Melamine fixed assets, goodwill and spare parts. This impairment was the result of Borden Chemical’s strategic decision late in 2001 to sell or close Melamine and to enter into a long-term contractual arrangement with a supplier for its future melamine crystal needs.

 

In June 2003, we initiated our 2003 realignment designed to reduce operating expenses and increase organizational efficiency. To achieve these goals, we reduced our workforce, streamlined processes, consolidated manufacturing processes and reduced general and administrative expenses.

 

Acquisitions and Divestitures. We are a New Jersey corporation with predecessors dating back to 1899. The following is a summary of acquisitions and divestitures we made in the past five years.

 

In 2001, we merged our foundry resins and coatings businesses with similar businesses of Delta-HA, Inc., or Delta, to form HA-International, or HAI, in which, at the time of its formation, we had a 75% economic interest. The Limited Liability Agreement of HAI provides Delta the right to purchase between 3% and 5% (up to a maximum of 25%) of additional economic interest in HAI each year beginning in 2004. Pursuant to this provision, in 2004, Delta purchased an additional 5% interest, thereby reducing our economic interest to 70%. In March 2005, Delta purchased an additional 5% interest, which reduced our economic interest to 65%.

 

Also in 2001, through a series of transactions with affiliates, Borden Chemical sold its Elmer’s consumer adhesives business for total proceeds of $94 million.

 

In the fourth quarter of 2003, we acquired Fentak in Australia and Malaysia, a producer of specialty chemical products for engineered wood, laminating and paper impregnation markets. We also acquired the business and technology assets of SEACO, a domestic producer of specialty adhesives. We undertook these tuck-in acquisitions to expand our existing product lines.

 

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Recent Developments

 

Acquisition of Decorative Coatings and Adhesives Business Unit of the Rhodia Group

 

On January 31, 2006, we acquired the decorative coatings and adhesives business unit of The Rhodia Group (the “Rhodia Acquisition”). The Rhodia business had 2004 sales of approximately $180 million, with 8 manufacturing facilities in Europe, Australia and Thailand. The acquisition was funded through a combination of available cash and existing credit lines.

 

Acquisition of Global Wax Compounds Business of Rohm and Haas

 

On March 1, 2006, we acquired the global wax compounds business of Rohm and Haas (the “Rohm and Haas Acquisition”). The purchase included Rohm and Haas’ wax compounds technology and product lines, manufacturing equipment and other business assets. The acquisition was funded through available cash.

 

Acquisition of the Global Ink and Adhesive Resins Business of Akzo Nobel

 

On November 25, 2005, we agreed to acquire the global ink and adhesive resins business of Akzo Nobel (the “Akzo Acquisition”). The business produces resins used to manufacture inks for commercial printing and packaging, digital inks for laser and photocopying printing, and pressure sensitive adhesives used in tape and labeling applications. The business generated 2004 sales of approximately $200 million, and includes 10 manufacturing facilities in Europe, North America, Argentina, Asia and New Zealand. Closing will occur upon the successful completion of normal governmental reviews and consultations with employee work’s councils, which we expect the closing to occur during the second quarter of 2006. The acquisition will be funded through a combination of available cash and existing credit lines.

 

The aggregate purchase amount of these three acquisitions is expected to be approximately $155 million.

 

 

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Products and Market Applications

 

The thermosets produced in each of our operating divisions and segments are used in two primary applications: adhesive & structural and coating. Within each primary application we operate in a diverse range of specialty chemical applications. Our primary products serving adhesive and structural applications include forest products resins, specialty phenolic resins, formaldehyde, epoxy resins, composite resins, phenolic encapsulated substrates and molding compounds. Our primary products serving coating applications include epoxy resins, polyester resins, alkyd resins, acrylic resins, ink resins and versatic acids and derivatives.

 

Adhesive & Structural Products and Market Applications

 

Formaldehyde Based Resins and Intermediates

 

We are the leading producer of formaldehyde based resins for the forest products industry in North America with a 44% market share by volume and also hold significant positions in Europe, Latin America and Australia. Our products are used in a wide range of applications in the construction, automotive, electronics and steel industries. We are also the world’s largest producer of specialty phenolic resins, which are used in applications that require extreme heat resistance and strength, such as automotive brake pads, foundry materials and oil field applications. In addition, we are the world’s largest producer of formaldehyde, a key building block chemical used in the manufacture of thousands of products. We internally consume the majority of our formaldehyde production, giving us a significant competitive advantage versus our non-integrated competitors.

 

Products


  

Key Applications


Forest Products Resins

    

Engineered Wood Resins

   Softwood and hardwood plywood, OSB, laminated veneer lumber, strand lumber and wood fiber resins such as particleboard, medium density fiberboard and finished veneer lumber

Special Wood Adhesives

   Laminated beams, structural and nonstructural fingerjoints, wood composite I-beams, cabinets, doors, windows, furniture, mold and millwork and paper laminations

Wax Emulsions

   Impacts moisture resistance for panel boards

 

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Products


  

Key Applications


Specialty Phenolic Resins

    

Composites and Electronic Resins

   Aircraft components, brakes, ballistic applications, industrial grating, pipe, jet engine components, electrical laminates, computer chip encasement and photolithography

Automotive PF Resins

   Acoustical insulation, engine filters, friction materials, interior components, molded electrical parts and assemblies
Construction PF Resins, UF Resins, Ketone Formaldehyde and Melamine Colloid    Decorative laminates, fiberglass insulation, floral foam, lamp cement for light bulbs, molded appliance and electrical parts, molding compounds, sandpaper, fiberglass mat, laminates, coatings, crosslinker for thermoplastic emulsions and specialty wet strength paper

Formaldehyde Applications

    

Formaldehyde

   Herbicides and fungicides, fabric softeners, sulphur scavengers for oil and gas production, urea formaldehyde, melamine formaldehyde, phenol formaldehyde, MDI and other catalysts

 

Epoxy Resins and Intermediates

 

We are the world’s largest supplier of epoxy resins. Epoxy resins comprise the fundamental building blocks of many types of materials, such as formulated composite resins and structural adhesives. Epoxy resins are often used in the auto, aerospace and electronics industries due to their unparalleled strength and durability. We also provide the industry with a variety of complementary products such as epoxy modifiers, curing agents, reactive diluents and specialty liquids. We are also a major producer of bisphenol-A (BPA) and epichlorohydrin (ECH), key precursors in the manufacture of epoxy resins. We internally consume the majority of our BPA and virtually all of our ECH, giving us a significant competitive advantage versus our non-integrated competitors.

 

Products


  

Key Applications


Composites

   Automotive (structural interior), sports (ski, snowboard), boat construction, aerospace, wind energy and industrial applications

Civil Engineering

   Bridge and canal construction, concrete enhancement and corrosion protection

Electrical Casting

   Generators and bushings, transformers, medium- and high-voltage switch gear components, post insulators, capacitors and automotive ignition coils

Adhesives

   Automotive: hem flange adhesives and panel reinforcement in car components
     Construction: ceramic tiles, chemical dowels and marble
     Aerospace: metal and composite laminates
     Electronics: chip adhesives, solder masks and electronic inks

Electrical Laminates

   Industrial laminates: unclad sheets, tube and molding, impregnation of paper, cotton and glass filament and printed circuit boards

 

 

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Composite Resins

 

We are a leading producer of resins used in composites. Composites are a fast growing class of materials which are used in a wide variety of applications ranging from airframes and windmill blades to golf clubs. We supply epoxy resins to fabricators in the aerospace, sporting goods and pipe markets with a 50% market share in the United States and a 44% market share in Europe. Our leadership position in epoxy resins, along with our technology and service expertise, enables us to selectively forward integrate into custom formulations for specialty composites, such as turbine blades used in the wind energy market. In addition to epoxy, we manufacture resins from unsaturated polyester (UPR), which are generally combined with fiberglass to produce cost-effective finished structural parts for applications ranging from boat hulls to recreational vehicles to bathroom fixtures.

 

Products


  

Key Applications


Reinforced-Epoxy unsaturated polyester and vinyl ester resins    Marine, transportation, construction, consumer products, recreational vehicles, spas, bath and shower surrounds
Non-reinforced-unsaturated polyester and vinyl ester resins    Cultured marble, construction, gel coat and surface coating and automotive putty

 

Phenolic Encapsulated Substrates

 

We are a leading producer of phenolic encapsulated sand and ceramic substrates used in oil field services and foundry applications. Our highly specialized compounds are designed to perform under extreme conditions, such as intense heat, high-stress and corrosive environments, that characterize the oil and gas drilling and foundry industries. In the oil field services industry we have a 45% global market share in resin encapsulated proppants, which are used to enhance oil and gas recovery rates and extend well life. We are also the leading producer by volume of foundry resins in North America with a 48% market share. Our foundry resin systems are used by major automotive and industrial companies for precision casting of engine blocks, transmissions, brake and drive train components. In addition to encapsulated substrates, our foundry resins business provides phenolic resin systems and ancillary products used to produce finished metal castings.

 

Products


  

Key Applications


Oil Field Service Applications

    

XRT® Resin Systems

   Patent pending resin technology for extreme flowback and fracture conductivity conditions for ceramics, bauxite and premium sands
Curable Resin-Coated Sand, ACFRAC® SB Excel, Black Plus CR 4000    Systems that increase strength and control proppant flowback on medium grade sand systems

Precured Resin-Coated Sand

PR 6000

   System to gently enhance crush resistance and high flow capacities with all grades of sand proppants

Foundry Applications

    

Refractory Coatings

   General purpose products for ferrous and nonferrous applications
RESINS-SIGMACURE®, SIGMASET®, SUPER SET®, ALpHASET®, BETASET® and PLASTIFLAKE®    A comprehensive selection of synthetic resins for bonding sand cores and molds in a variety of applications including phenolic urethane cold box resins, phenolic urethane nobake resins, furan and phenolic acid curing resins, ester cured phenolic nobake resins, methyl formate cured phenolic cold box resins and phenolic resins for shell process

 

 

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Molding Compounds

 

We are the leading producer of molding compounds in Europe, with an estimated market share of 64%. We formulate and produce a wide range of phenolic, polyester and epoxy compounds used to manufacture components requiring heat stability, electrical insulation, fire resistance and durability. Applications range from automotive underhood components to appliance knobs and cookware handles.

 

Products


  

Key Applications


Phenolic, Epoxy, Vinylester

   Automotive ashtrays and under hood components, heat resistant knobs and bases, switches and breaker components and pot handles

Long Fiber Reinforced MC

   High load, dimensionally stable automotive underhood parts and commutators

PBT, PET, PC, PC-ABS, PA6 and PA66

   Connectors, switches, bobbins, wheel covers, power tool internal components and bodies

 

Coating Products and Market Applications

 

Epoxy Coating Resins

 

In addition to the adhesive uses mentioned previously, epoxy resins are used for a variety of high-end coating applications which require the superior strength and durability of epoxy. Examples include protective coating for industrial and domestic flooring, pipe, marine and construction applications, powder coatings and automotive coatings. Where advantageous, we leverage our resin and additives position to supply custom resins for specialty coatings formulators.

 

Products


  

Key Applications


Electrocoat (LER, SER, BPA)

   Automotive, general industry (heating radiators), white goods

Powder Coatings (SER, Performance Products)

   White goods (appliances), pipes (oil and gas transportation), general industry (heating radiators, all types of metal objects) and automotive (interior parts and small components)

Heat Cured Coatings (LER, SER)

   Metal packaging, coil coated steel for construction and general industry
Floor Coatings (LER, Solutions, Performance Products)    Chemically resistant, antistatic and heavy duty flooring in hospitals, chemical industry, electronics workshops, retail areas and warehouses
Ambient Cured Coatings (LER, SER, Solutions, Performance Products)    Marine (new build and maintenance), shipping containers and large steel structures (bridges, pipes, plants and offshore equipment)

Waterborne Coatings

   Replacing solvent-borne products in both heat cured and ambient cured applications

 

Polyester Resins

 

We are a leading supplier of polyester coatings resins in North America with a market share of 10% and are also a major producer in Europe with a powder coatings market share of 10%. We provide custom polyester resins, both liquid and powder, to customers for use in industrial coatings requiring specific properties such as gloss and color retention, resistance to corrosion and flexibility. Polyester coatings are typically used in transportation, automotive, machinery, appliances and metal office furniture. Our polyester resins business shares an integrated production platform with our alkyd business, which allows for flexible sourcing, plant balancing and economies of scale.

 

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Products


  

Key Applications


Powder Polyesters

   Outdoor durable systems for architectural window frames, facades and transport; indoor systems for domestic appliances and general industrial applications

Liquid Polyesters and polyester dispersions

   Automotive, coil and exterior can coating applications

 

Alkyd Resins

 

We share the leading position in alkyd resins in North America with a market share of 31% and are a major producer in Europe, specifically in Scandinavia and Italy. We provide alkyd resins to customers for use in the manufacture of professional grade paints and coatings. Alkyd resins are formulated and engineered according to customer specifications, and can be modified with other raw materials to improve performance. Applications include industrial coatings (e.g., protective coatings used on machinery, metal coil, equipment, tools and furniture), special purpose coatings (e.g., highway-striping paints, automotive refinish coatings and industrial maintenance coatings) and decorative paints (e.g., house paint and deck stains). Our alkyd resins business shares an integrated production platform with our polyester resins business, which allows for flexible sourcing, plant balancing and economies of scale.

 

Products


  

Key Applications


Alkyd and Alkyd Emulsions

   Architectural Markets: Exterior enamels, interior semi-gloss and trim, interior/exterior stains and wood primers
     Industrial Markets: Metal primers, general metal, transportation, machinery and equipment, industrial maintenance and marine, metal container and wood furniture

Alkyd Copolymer

   Architectural Markets: Stain blocking primer, sanding sealers and aerosol
     Industrial Markets: Machinery and equipment, transportation, general metal and drywall coating

Urethane Modified

   Architectural Markets: Clear varnishes (DIY) and floor coatings
     Industrial Markets: Wood coatings

Silicone Alkyd

   Industrial Markets: Industrial maintenance and marine and heat resistance coatings

 

Acrylic Resins

 

We are a supplier of acrylic resins (solvent and water-based) in North America and Europe. Acrylic resins are used for interior trim paints and exterior applications where weathering protection, color and gloss retention are critical. In addition, we produce a wide range of specialty acrylic resins for marine and maintenance paints and automotive topcoats. We are also a low cost producer of acrylic monomer, the key raw material for our acrylic resins. This ability to internally produce key raw materials gives us a competitive cost advantage relative to our competitors and ensures adequacy of supply.

 

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Products


  

Key Applications


Acrylic Dispersions

   Architectural Markets: Interior semi-gloss & high gloss, interior and exterior paints, stains and sealers, drywall primer, masonry coatings and general purpose
     Industrial Markets: Automotive OEM, packaging, general metal, wood, plastic coatings, traffic marking paint, industrial maintenance and transportation, adhesives and textiles

Solutions Acrylics

   Architectural Markets: Aerosol, masonry and tile sealer
     Industrial Markets: Transportation, packaging, aerosol, automotive OEM, appliance, industrial maintenance and marine and road marking

 

Ink Resins and Additives

 

We are the world’s largest producer of ink resins and associated products, with a market share of 15%. Ink resins are used to apply ink to a variety of different substrates including paper, cardboard, metal foil and plastic. We provide resins, liquid components and additives, sold primarily under the globally recognized Lawter brand name to customers formulating inks for a variety of substrates and printing processes. Our products offer such performance enhancements as durability, printability, substrate application, drying speed and security. Typical end use applications include brochures, newspapers, magazines, food packages, beverage cans and flexible packaging. We are also a provider of formulated UV-cure coatings and inks. Our proprietary technology has enabled us to gain a leading position in the global fiber optic market.

 

Products


  

Key Applications


Resins

   Graphic arts, commercial, publication and packaging

Vehicles and waxes

   Sheet-fed, heatset, gloss and wetting vehicles and wax products

Liquid Inks

   Polymer films, paper and corrugated boards

 

Versatic Acids and Derivatives

 

We are the world’s largest producer of versatic acids and derivatives, with a market share of 76%. Versatic acids and derivatives are specialty monomers which provide significant performance advantages to finished coatings, including superior adhesion, flexibility, ease of application and other high performance characteristics. The products include basic versatic acids and derivatives sold under the Versatic, VEOVA® and CARDURA® names. Applications for versatic acids include decorative, automotive and protective coatings as well as other uses, such as pharmaceuticals and personal care products. We manufacture versatic acids and derivatives using our integrated manufacturing sites and our internally produced ECH.

 

Products


  

Key Applications


Cardura

   Automotive repair/refinishing, automotive OEM and industrial coating

Versatic

   Chemical building block, peroxides, pharmaceuticals and agrochemicals

VeoVa

   Architectural coatings and construction

 

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Segments

 

The products and market applications discussion above provided information organized around our primary applications (adhesives & structural and coating), while our organizational structure is based on the thermoset products we offer and the markets we serve. During the fourth quarter of 2005, we changed our reportable segments to better reflect the stage of the transition from the previous organization of our pre-merger companies to the Company’s organizational structure during the latter half of 2005. The transition provides greater alignment with the respective operating divisions and reporting segments. At December 31, 2005, our organizational structure consisted of four operating divisions that are directly aligned with our reportable segments: Epoxy and Phenolic Resins, Formaldehyde and Forest Products Resins, Coatings and Inks, and Performance Products. A brief summary of the major products and primary applications of our operating divisions, which aligned with the Company’s reportable segments, is as follows:

 

Epoxy and Phenolic Resins
2005 Net Sales    $1,909

Major Products:

Epoxy resins and intermediates

Molding compounds

Versatic acids and derivatives

Formaldehyde based resins and intermediates:

•    Specialty phenolic resins

Epoxy coating resins

  

Primary Application:

Adhesive & Structural

Adhesive & Structural

Coating

 

Adhesive & Structural

Coating

 

Formaldehyde and Forest Products Resins
2005 Net Sales    $1,281

Major Products:

Formaldehyde based resins and intermediates:

•    Formaldehyde applications

•    Forest products resins

  

Primary Application:

 

Adhesive & Structural

Adhesive & Structural

 

Coatings and Inks
2005 Net Sales    $886

Major Products:

Composite resins

Polyester resins

Acrylic resins

Alkyd Resins

Ink resins and additives

  

Primary Application:

Adhesive & Structural

Coating

Coating

Coating

Coating

 

Performance Products
2005 Net Sales    $394

Major Products:

Phenolic Encapsulated Substrates:

•    Oil field service applications

•    Foundry applications

  

Primary Application:

 

Adhesive & Structural

Adhesive & Structural

 

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All historical segment information included herein has been restated to conform with our current segment reporting. The changes to previously reported segment information are simply a reclassification of activity among the Company’s segments and they do not impact any of the Company’s previously reported consolidated results.

 

We began implementing additional refinements to our operating divisions in 2006 to more closely link similar products, minimize divisional boundaries and improve our ability to serve common customers from pre-merger legacy company relationships which may result in additional refinements to our reporting segments.

 

Marketing and Distribution

 

Products are sold to industrial users throughout the world through our direct sales force to larger customers and through third-party distributors to serve our smaller customers more cost effectively. Our direct sales force, customer service and support network consists of 319 employees in the Americas, 202 employees in Europe/Africa/Middle East and 36 employees in Asia-Pacific. Our customer service and support network is organized into key regional customer service centers. We have global account teams that focus on coordination for major global customers, including technical service, supply and commercial terms. Furthermore, where operational and regulatory factors vary meaningfully from country to country, we organize locally.

 

Competition

 

We compete with a variety of companies, including large global chemical companies and small specialty chemical companies, in each of our product lines. In addition, we face competition from a number of products that are potential substitutes for formaldehyde-based resins. The principal factors of competition in our industry include technical service, breadth of product offering, product innovation, and price. Some of our competitors are larger, have great financial resources and have less debt than we do and may, as a result, be better able to withstand changes in conditions throughout our industry relating to pricing or otherwise and the economy as a whole. We are able to compete with smaller niche specialty chemical companies due to our significant investment in research and development and our customer service model which provides for on-site value added technical service for our customers. In addition, our size and scale provides us significant efficiencies in our cost structure.

 

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We believe that no single company competes with us across all of our existing product lines. The following charts sets forth our principal competitors by market application.

 

Adhesive & Structural Products and Market Application

 

Major Products


       

Principal Competitors


Forest Products Resins         Dynea International, Georgia-Pacific and Kronospan
Specialty Phenolic Resins         Dynea International, Occidental Petroleum, Schenectady, Ashland and PA Resins
Formaldehyde Applications         Dynea International and Georgia-Pacific
Epoxy Resins and Intermediates         Huntsman, Dow Chemical, Nan Ya and the Formosa Plastics Group, Chang Chun Polymers and Thai Epoxy
Composite Resins         Huntsman, Dow Chemical, Ashland, AOC, Reichhold and CCP/Atofina
Phenolic Encapsulated Substrates         Ashland, Carbo Ceramics, Santrol and Dynea International
Molding Compounds         Dynea International, FAR and Sumitomo

 

Coating Products and Market Application

 

Major Products


       

Principal Competitors


Epoxy Coating Resins         Dow Chemical, Huntsman, Nan Ya and the Formosa Plastics Group, Leuna and Kuk-do
Polyester Resins         DSM, Cytec, Cray Valley/CCP, Reichhold, Nuplex and EPS (owned by Valspar)
Alkyd Resins         Reichhold, CCP/Atofina/Cray Valley, DSM, Nuplex and EPS (owned by Valspar)
Acrylic Resins         Rohm & Haas, BASF, Dow Chemical, Cognis and DSM (Neoresins)
Ink Resins and Additives         Mead Westvaco, Akzo Nobel, Arizona, Resinall, Arakawa and Harima
Versatic Acids and Derivatives         ExxonMobil and Tianjin Shield

 

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Raw Materials

 

Raw material costs make up approximately 80% of our product costs. In 2005, we purchased approximately $3 billion of raw materials. The three largest raw materials utilized in our production processes are phenol, methanol and urea, which represented 49% of our total raw material expenditures. The majority of raw materials used in the manufacturing of our products are available from more than one source and are readily available in the open market. We use long-term purchase agreements for our primary and certain other raw materials to ensure availability of adequate supplies. These agreements generally have periodic price adjustment mechanisms and do not have minimum annual purchase requirements. Those smaller quantity materials that are single sourced generally have long-term supply contracts as a basis to guarantee a maximum of supply reliability. Prices for our main feedstocks are generally driven by underlying petrochemical benchmark prices and energy costs. These raw materials are subject to price fluctuations. Although we seek to offset increases in raw material prices with increases in our product prices, we may not always be able to do so, and there may be periods when such product price increases lag behind raw material price increases.

 

Customers

 

In 2005, our largest customer accounted for 3% of our net sales and our top ten customers accounted for 18% of our net sales. Neither our business nor any of our reporting segments depend on any single customer or a particular group of customers, the loss of which would have a material adverse effect on such a reporting group. Our primary customers consist of manufacturers, and the demand for our products is generally not seasonal.

 

Patents and Trademarks

 

We own, license or have rights to over 1,000 patents, over 1,500 trademarks and various patent and trademark applications and technology licenses in our reporting groups around the world, which are held for use or currently used in our operations. Our most significant trademarks are BORDEN®, RESOLUTION®, EPIKOTE® Resins, EPON® Resins, EPIKURE® Curing Agents, EPI-REZ® Waterborne Resins, AQUAMAC®, DURAMAC®, POLYMAC®, ACRYLIMAC®, HELOXY® Modifiers, CARDURA® Glycidyl Ester, VEOVA® Monomers, VERSATIC acids, LAWTER, McWhorter® and ERNST JAEGER®. We use BORDEN® in our operations and license the trademark to third parties for use on non-chemical products. A majority of our patents relate to the development of new products and processes for manufacturing and use thereof and will expire at various times between 2006 and 2026. We renew our trademarks on a regular basis. Bakelite owns numerous foreign registrations of the trademark Bakelite, which it uses in its operations and has licensed to a limited number of third parties on a non-exclusive basis. No individual patent or trademark is considered to be material; however, our overall portfolios of patents and trademarks are valuable assets.

 

Environmental Regulations

 

Our operations involve the use, handling, processing, storage, transportation and disposal of hazardous materials and are subject to extensive environmental regulation at the federal, state and international level and are exposed to the risk of claims for environmental remediation or restoration. Our production facilities require operating permits that are subject to renewal or modification. Violations of environmental laws or permits may result in restrictions being imposed on operating activities, substantial fines, penalties, damages or other costs. In addition, statutes such as the federal Comprehensive Environmental Response, Compensation, and Liability Act and comparable state and foreign laws impose strict, joint and several liability for investigating and remediating the consequences of spills and other releases of hazardous materials, substances and wastes at current and former facilities, and at third-party disposal sites. Other laws permit individuals to seek recovery of damages for alleged personal injury or property damage due to exposure to hazardous substances and conditions at our facilities or to hazardous substances otherwise owned, sold or controlled by us. Therefore, notwithstanding our commitment to environmental management, environmental, health and safety liabilities may be incurred in the future, and such liabilities may result in a material adverse effect on our business, financial condition, results of operations or cash flows.

 

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Accruals for environmental matters are recorded in accordance with the guidelines of the AICPA Statement of Position 96-1, “Environmental Remediation Liabilities,” when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated. Although our environmental policies and practices are designed to ensure compliance with international, federal and state laws and environmental regulations, future developments and increasingly stringent regulation could require us to make additional unforeseen environmental expenditures. In addition, our former operations, including our ink, wall coverings, film, phosphate mining and processing, thermoplastics, food and dairy operations, may give rise to claims relating to our period of ownership. We cannot assure you that, as a result of former, current or future operations, there will not be some future impact on us relating to new regulations or additional environmental remediation or restoration liabilities.

 

We have adopted and implemented health, safety and environmental policies, which include systems and procedures governing environmental emissions, waste generation, process safety management, handling, storage and disposal of hazardous substances, worker health and safety requirements, emergency planning and response, and product stewardship. We anticipate incurring future costs for capital improvements and general compliance under environmental laws, including costs to acquire, maintain and repair pollution control equipment. In 2005, we incurred related capital expenditures of $18 million. We estimate that $27 million will be spent for capital expenditures in 2006 for environmental controls at our facilities. This estimate is based on current regulations and other requirements, but it is possible that material capital expenditures in addition to those currently anticipated could be required if regulations or other requirements change.

 

Industry Regulatory Matters

 

The production and marketing of chemical substances are regulated by national and international laws. Although almost every country has its own legal procedure for registration and import, laws and regulations in the European Union, the United States and China are most significant to our business, including the European inventory of existing commercial chemical substances, the European list of notified chemical substances and the United States Toxic Substances Control Act inventory. Chemicals which are on one or more of the above lists can usually be registered and imported without additional testing in other countries, although additional administrative hurdles may exist.

 

We also actively seek approvals from the U.S. Food and Drug Administration for certain specialty chemicals produced by us, principally where we believe that these specialty chemicals will or may be used by our customers in the manufacture of products that will come in direct or indirect contact with food.

 

Research and Development

 

Our research and development activities are aimed at developing and enhancing products, processes, applications and technologies to maintain our position as the world’s largest producer of thermoset resins. We focus on:

 

    developing new or improved applications based on our existing product line and identified customer needs;

 

    developing new resin products and applications for customers in order to improve their competitive advantage and profitability;

 

    providing premier technical service for customers of specialty products;

 

    providing technical support for manufacturing locations and assisting in plant optimization;

 

    ensuring that our products are manufactured in accordance with our global environmental, health and safety policies and objectives;

 

    developing lower cost manufacturing processes globally; and

 

    expanding production capacity.

 

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In 2005, 2004 and 2003, our research and development and technical services expenses were $62 million, $30 million and $16 million, respectively. Development and marketing of new products are carried out by our reporting groups and are integrated with quality control for existing product lines. We emphasize a customer driven, “systems and solutions” approach in discovering new applications and processes and providing excellent customer service through our technical staff. Through regular direct contact with our key customers, our research and development personnel can become aware of evolving customer needs in advance and can anticipate their requirements in planning customer programs. We also focus on on-going improvement of plant yields, fixed costs and capacity. These continuous integrated streams are characterized by exceptional product consistency, low cost economics and high quality resin that is valued by the customer for demanding applications. We estimate that this process provides us with a sustainable cost advantage over conventional batch technology, which is the traditional method of manufacturing certain resins.

 

We have over 600 scientists and technicians worldwide. We conduct research and development activities primarily at our facilities located in Carpentersville, Illinois; Louisville, Kentucky; Cincinnati, Ohio; Springfield, Oregon; Roebuck, South Carolina; Houston, Texas; Pleasant Prairie, Wisconsin; Kallo, Belgium; Louvian-la-Neuve, Belgium; Tianjin, China; Sokolov, Czech Republic; Duisburg, Germany; Iserlohn, Germany; Sant’ Albano, Italy; Pernis, The Netherlands and Barry, South Wales, UK. Our research and development facilities include a broad range of synthesis, testing and formulating equipment, and small scale versions of customer manufacturing processes for applications development and demonstration. In addition, we have an agreement with a not-for-profit research center to assist in certain research projects and new product development initiatives.

 

Employees

 

At December 31, 2005, we had approximately 7,000 employees. Approximately 46% of our employees are members of a labor union or represented by workers’ councils that have collective bargaining agreements. Most of our European employees are represented by works councils. Relationships with our union and non-union employees are generally satisfactory.

 

Where You Can Find More Information

 

Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to these reports are available free of charge to the public through our internet website at www.hexion.com under “Investor Relations - SEC Filings.”

 

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ITEM 1A. RISK FACTORS

 

Any of the following risks could materially adversely affect our business, financial condition or results of operations and prospects.

 

Borden Chemical, Resolution Performance, Resolution Specialty and Bakelite have a limited history of working together as a single company. Should we fail to integrate the operations of Borden Chemical, Resolution Performance, Resolution Specialty and Bakelite and achieve cost savings, our results of operations and profitability would be negatively impacted.

 

We may not be successful integrating Borden Chemical, Resolution Performance, Resolution Specialty and Bakelite, and the combined company may not perform as we expect or achieve the net cost savings we anticipate. A significant element of our business strategy is the improvement of our operating efficiencies and a reduction of our operating costs. Management is currently targeting $250 million in synergies from the Hexion Formation of which $125 million of cost savings have been specifically identified. We achieved cost savings of $20 million in 2005. We expect to incur one-time costs of $75 million in connection with implementing these synergies. A variety of factors could cause us not to achieve the benefits of the cost savings plan, or could result in harm to our business. For example, certain of our European operations utilize IT systems with limited systems support. In the event we are not able to integrate these systems with our more advanced IT systems, our ability to efficiently operate in certain European countries could be diminished. In addition, the impact of Hurricanes Katrina and Rita on our business, along with future hurricanes and natural disasters, may affect our ability to achieve our cost savings plan in the near term. Additional factors include:

 

    delays in the anticipated timing of activities related to our cost savings plan;

 

    higher than expected or unanticipated costs to implement the plan and to operate the business;

 

    inadequate resources to implement the plan and to operate the business;

 

    our inability to optimize manufacturing processes between the companies;

 

    our inability to obtain lower raw material prices;

 

    our inability to utilize new geographic distribution channels;

 

    our inability to reduce corporate and administrative expenses; and

 

    our inability to identify an additional $125 million of cost savings consistent with our synergy target.

 

As a result, we may not achieve our expected cost savings in the time anticipated, or at all. In such case, our results of operations and profitability would be negatively impaired.

 

The Hexion Formation may prove disruptive and could result in the combined business failing to meet our expectations.

 

The continuing process of integrating the operations of Borden Chemical, Resolution Performance, Resolution Specialty and Bakelite may continue to require a disproportionate amount of resources and management attention. Our future operations and cash flows will depend largely upon our ability to operate Hexion efficiently, achieve the strategic operating objectives for our business and realize significant cost savings and synergies. Our management team may encounter unforeseen difficulties in managing the integration of our four businesses. In order to successfully combine and operate our businesses, our management team will need to

 

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continue to focus on realizing anticipated synergies and cost savings on a timely basis while maintaining the efficiency of our operations. Any substantial diversion of management attention or difficulties in operating the combined business could affect our sales and ability to achieve operational, financial and strategic objectives. For example, we expect to devote substantial management attention in order to implement financial reporting and other systems that will permit us to utilize a shared service business model (for certain processes) along with a single company wide SAP® system.

 

Our historical and pro forma financial information may not reflect what our actual results of operations and financial condition would have been had we been a combined company for the periods presented and thus these results may not be indicative of our future operating performance.

 

The historical financial information included in this prospectus is constructed from the separate financial statements of Resolution Performance, Borden Chemical and Resolution Specialty for periods prior to the consummation of the Hexion Formation. In addition, Bakelite has historically prepared its financial statements in accordance with German GAAP, which differs in certain respects from US GAAP. The Bakelite financial statement presentation included in this prospectus has been converted from the local GAAP of Bakelite and its subsidiaries to US GAAP. The pro forma financial information presented in this prospectus is based in part on certain assumptions regarding the Hexion Formation that we believe are reasonable. Our assumptions may prove to be inaccurate over time. Accordingly, the historical and pro forma financial information included in this prospectus may not reflect what our results of operations and financial condition would have been had we been a combined entity during the periods presented, or what our results of operations and financial condition will be in the future.

 

Our limited operating history and the challenge of integrating previously independent businesses make evaluating our business and our future financial prospects difficult. Our potential for future business success and operating profitability must be considered in light of the risks, uncertainties, expenses and difficulties typically encountered by recently organized or combined companies.

 

Although EBITDA is derived from the financial statements (pro forma or historical, as the case may be) of Hexion, the calculation of Adjusted EBITDA contains a number of estimates and assumptions that may prove to be incorrect. For example, the synergies assume we can obtain improved raw materials pricing, the determination of legacy corporate expenses, net contains an estimate as to the cost of replacement services and business realignment expenses contains a number of assumptions as to excess costs. Although management of Hexion believes these estimates and assumptions are reasonable and correct and are consistent with the definition of Adjusted EBITDA in our indentures, investors should not place undue reliance upon Adjusted EBITDA as an indicator of current and future performance.

 

Our substantial indebtedness could adversely affect our ability to raise additional capital to fund our operations, limit our ability to react to changes in the economy or our industry and prevent us from fulfilling our obligations under our existing or future indebtedness.

 

We are a highly leveraged company. As of December 31, 2005, we had $2.4 billion of outstanding indebtedness. In fiscal 2006, our cash debt service is expected to be approximately $268 million (including $51 million of short term debt maturities) based on current interest rates, of which $146 million represents debt service on fixed-rate obligations. Our ability to generate sufficient cash flow from operations to make scheduled payments on our debt depends on a range of economic, competitive and business factors, many of which are outside our control. Our business may not generate sufficient cash flow from operations to meet our debt service and other obligations, and currently anticipated cost savings and operating improvements may not be realized on schedule, or at all. If we are unable to meet our expenses and debt service obligations, we may need to refinance all or a portion of our indebtedness on or before maturity, sell assets or raise equity. We may not be able to refinance any of our indebtedness, sell assets or raise equity on commercially reasonable terms or at all, which could cause us to default on our obligations and impair our liquidity.

 

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Our substantial indebtedness could have important consequences for you, including the following:

 

    it may limit our ability to borrow money or sell stock for our working capital, capital expenditures, dividend payments, debt service requirements, strategic initiatives or other purposes;

 

    it may limit our flexibility in planning for, or reacting to, changes in our operations or business;

 

    it may increase the amount of our interest expense, because certain of our borrowings are at variable rates of interest, which, if interest rates increase, could result in higher interest expense;

 

    we are more highly leveraged than some of our competitors, which may place us at a competitive disadvantage;

 

    it may make us more vulnerable to downturns in our business or the economy;

 

    a substantial portion of our cash flow from operations will be dedicated to the repayment of our indebtedness and will not be available for other purposes;

 

    it may restrict us from making strategic acquisitions, introducing new technologies or exploiting business opportunities;

 

    it may make it more difficult for us to satisfy our obligations with respect to our existing indebtedness; and

 

    it may limit, along with the financial and other restrictive covenants in our indebtedness, among other things, our ability to borrow additional funds or dispose of assets.

 

Our variable-rate indebtedness subjects us to interest rate risk, which could cause our annual debt service obligations to increase significantly.

 

Certain of our indebtedness, including indebtedness under our floating rate notes and borrowings under our senior secured credit facilities, are at variable rates of interest and expose us to interest rate risk. See “Description of Certain Indebtedness.” If interest rates increase, our debt service obligations on the variable rate indebtedness would increase even though the amount borrowed remained the same. Assuming the amount of variable rate indebtedness remains the same, an increase of 1% in the interest rates payable on our variable rate indebtedness would increase our fiscal 2006 estimated debt service requirements by approximately $8 million. Accordingly, an increase in interest rates from current levels could cause our annual debt-service obligations to increase significantly.

 

Despite our substantial indebtedness we may still be able to incur significantly more debt. This could intensify the risks described above.

 

The terms of the indentures governing our notes, our senior secured credit facilities and the instruments governing our other indebtedness and Series A Preferred Stock contain restrictions on our ability to incur additional indebtedness. These restrictions are subject to a number of important qualifications and exceptions and the indebtedness incurred in compliance with these restrictions could be substantial. Accordingly, we could incur significant additional indebtedness in the future. As of December 31, 2005, we had $221 million available for additional borrowing under our senior secured credit facilities, including the subfacility for letters of credit, and the covenants under our debt agreements would allow us to borrow a significant amount of additional indebtedness. The more we become leveraged, the more we, and in turn our securityholders, become exposed to the risks described above under “—Our substantial indebtedness could adversely affect our ability to raise additional capital to fund our operations, limit our ability to react to changes in the economy or our industry and prevent us from fulfilling our obligations under our existing or future indebtedness.”

 

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The terms of our senior secured credit facilities and our existing indebtedness may restrict our current and future operations.

 

Our senior secured credit facilities and our existing indebtedness contain, and any future indebtedness we incur would likely contain, a number of restrictive covenants that will impose significant operating and financial restrictions on our ability to, among other things:

 

    incur or guarantee additional debt;

 

    pay dividends and make other distributions to our shareholders;

 

    create or incur certain liens;

 

    make certain loans, acquisitions, capital expenditures or investments;

 

    engage in sales of assets and subsidiary stock;

 

    enter into sale/leaseback transactions;

 

    enter into transactions with affiliates;

 

    transfer all or substantially all of our assets or enter into merger or consolidation transactions; and

 

    make capital expenditures.

 

In addition, our senior secured credit facilities require us to maintain a maximum senior secured bank leverage ratio. As a result of these covenants and this ratio, we are limited in the manner in which we conduct our business and we may be unable to engage in favorable business activities or finance future operations or capital needs. While we are currently in compliance with all of the terms of our outstanding indebtedness, including the financial covenants contained therein, a downturn in our business could cause us to fail to comply with the financial or other covenants in our senior secured credit facilities.

 

A failure to comply with the covenants contained in our senior secured credit facilities or our existing indebtedness could result in an event of default under the facilities or the existing agreements. In the event of any default under our senior secured credit facilities or our other indebtedness, the lenders thereunder:

 

    will not be required to lend any additional amounts to us;

 

    could elect to declare all borrowings outstanding, together with accrued and unpaid interest and fees, to be due and payable;

 

    require us to apply all of our available cash to repay these borrowings; or

 

    prevent us from making payments on the Series A Preferred Stock.

 

If the indebtedness under our senior secured credit facilities or our other indebtedness were to be accelerated, our assets may not be sufficient to repay such indebtedness in full. See “Description of Certain Indebtedness.”

 

Demand for many of our products is cyclical and we may experience prolonged depressed market conditions for our products, which may decrease our net sales and operating margins.

 

Many of our products are used in industries that are cyclical in nature, such as the new home construction, automotive, oil and gas, chemicals and electronics industries. We sell our products to manufacturers in those industries who incorporate them into their own products. Sales to the construction industry are driven by trends in commercial and residential construction, housing starts and trends in residential repair and remodeling. Consumer confidence, mortgage rates and income levels play a significant role in driving demand in the residential construction, repair and remodeling sector. A drop in consumer confidence or an increase in mortgage rates or unemployment could cause a slowdown in the construction industry, and in particular the residential construction, repair and remodeling industry. These and other similar adverse developments could cause a material decrease in our net sales and operating margins.

 

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Downturns in one or more of the other businesses that use our products can adversely affect our net sales and operating margins. Many of our customers are in businesses that are cyclical in nature and sensitive to changes in general economic conditions. In 2002, sales of Borden Chemical’s oil field services products declined 29% as a result of reduced drilling activity. Demand for our products depends, in part, on general economic conditions, and a decline in economic conditions in the industries served by our customers has, and may continue to have, a material adverse effect on our business. An economic downturn in one or more of the businesses or geographic regions in which we sell our products could cause a material decrease in our net sales and operating margins.

 

We rely significantly on raw materials in the production of our products and fluctuations in costs would increase our operating expenses.

 

Our manufacturing operations depend upon obtaining adequate supplies of our raw materials on a timely basis. The loss of a key source of supply or a delay in shipments could have an adverse effect on our business. In addition, several of our feedstocks at various facilities are transported through a pipeline from one supplier. If we were unable to receive these feedstock through these pipeline arrangements, we may not be able to obtain them from other suppliers at competitive prices or in a timely manner. During the past three years, the prices of these materials have been volatile. We are exposed to price risks associated with these raw material purchases. The availability and prices of raw materials may be subject to curtailment or change due to, among other things, new laws or regulations, suppliers’ allocations to other purchasers, interruptions in production by suppliers, changes in exchange rates, cost components of raw materials and worldwide price levels. In addition, we may be subject to increasing raw material prices and fuel surcharges due to hurricanes, such as Hurricanes Katrina and Rita in 2005, and other natural disasters and the associated damage to our suppliers. In 2005, approximately $27 million of incremental expenses associated with Hurricanes Katrina and Rita negatively impacted our results. Our ability to manufacture products depends on our ability to obtain an adequate supply of raw materials in a timely manner. Furthermore, if the cost of raw materials increases significantly and we are unable to offset the increased costs with higher selling prices, our profitability will decline. From time to time, suppliers may extend lead times, limit supplies or increase prices due to capacity constraints or other factors. Although certain of our contracts include competitive price clauses that allow us to buy outside the contract if market pricing falls below contract pricing and other contracts have minimum-maximum monthly volume commitments that allow us to take advantage of spot pricing, we may not be able to purchase raw materials at market price. In addition, some of our customer contracts include selling price provisions that are indexed to publicly available indices for these commodity raw materials; however, we may not be able to immediately pass on raw material price increases to our customers, if at all. Due to differences in timing of the pricing mechanism trigger points between our sales and purchase contracts, there is often a “lead-lag” impact during which margins are negatively impacted for the short term in periods of rising raw material prices and positively impacted in periods of falling raw material prices. Raw material prices may not decrease from currently high levels or, if they do, we may not be able to capitalize on any such reductions in a timely manner, if at all.

 

Rising energy costs have previously increased our operating expenses and reduced net income and may in the future continue to do so, which could have a negative impact on our financial condition.

 

Natural gas is essential in our manufacturing processes, and its cost can vary widely and unpredictably. Our energy costs represented approximately 4% of our total cost of sales in 2005. Energy costs have risen significantly over the past several years due to the increase in the cost of oil and natural gas and the recent shortages of energy in various states, including those caused by Hurricanes Katrina and Rita. Our operating expenses increased in 2005 and will continue to increase if these costs continue to rise or do not return to historical levels. Rising energy costs may also increase our raw material costs. If we cannot pass these costs through to our customers, our profitability may decline. In addition, rising energy costs also negatively impact our customers and the demand for our products. These risks will be exacerbated if our customers or production facilities are in locations experiencing severe energy shortages.

 

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Environmental obligations and liabilities could have a substantial negative impact on our financial condition, cash flows and profitability.

 

Our operations involve the use, handling, processing, storage, transportation and disposal of hazardous materials and are subject to extensive environmental laws and regulations at the national, state, local and international level. Such environmental laws and regulations include those governing the discharge of pollutants into the air and water, the management and disposal of hazardous materials and wastes, the cleanup of contaminated sites and occupational health and safety. We have incurred, and will continue to incur, significant costs and capital expenditures in complying with these laws and regulations. In 2005, we incurred $18 million in capital expenditures to comply with environmental laws and regulations, and for other environmental improvements. In addition, violations of environmental laws or permits may result in restrictions being imposed on our operating activities or in our being subjected to substantial fines, penalties, criminal proceedings, third party property damage or personal injury claims or other costs. In addition, future developments or increasingly stringent regulation could require us to make additional unforeseen environmental expenditures. For example, the Louisville Metro Air Pollution control district has proposed new regulations that, if promulgated in their current form, could result in increased costs at our Louisville, Kentucky facility. In addition, potential air compliance issues at the Louisville facility could adversely affect our ability to achieve operational synergies in a timely fashion.

 

Even if we fully comply with environmental laws, we are subject to liability associated with hazardous substances in soil, groundwater and elsewhere at a number of sites. These include sites that we formerly owned or operated, and sites where hazardous wastes and other substances from our current and former facilities and operations have been treated, stored or disposed of, as well as sites that we currently own or operate. Depending upon the circumstances, our liability may be joint and several, meaning that we may be held responsible for more than our proportionate share, or even all, of the liability involved. Environmental conditions at such sites can lead to claims against us for personal injury or wrongful death, property damages, and natural resource damage, as well as to claims and obligations for the investigation and cleanup of environmental conditions. The extent of any such liabilities can be difficult to predict.

 

We have been notified that we are or may be responsible for environmental remediation at a number of sites in the United States, Europe and South America, and we are also undertaking a number of voluntary cleanups. We believe the most significant of these and the site that makes up approximately half of our remediation accrual is the site formerly owned by us in Geismar, Louisiana. As a result of former, current or future operations, there are likely to be additional environmental remediation or restoration liabilities or claims of personal injury by employees or members of the public due to exposure or alleged exposure to hazardous materials in connection with our operations, properties or products. We are aware of several sites, sold by us over 20 years ago, that may have significant site closure or remediation costs. Actual costs at these sites, as well as our share, if any, are unknown to us at this time. In addition, we have been served in two tort actions relating to one of these sites. If we fail to mount a successful defense against legal proceedings involving former sites, any significant finding of liability could have a negative impact on our financial condition, cash flows and profitability.

 

These environmental liabilities or obligations, or any that may arise or become known to us in the future, could have a material adverse effect on our financial condition, cash flows and profitability.

 

Because we manufacture and use materials that are known to be hazardous, we are subject to comprehensive product and manufacturing regulations, for which compliance can be costly and time consuming.

 

We produce hazardous chemicals that require care in handling and use and are subject to regulation by many U.S. and non-U.S. national, supra-national, state and local governmental authorities. In some circumstances, before we may sell some of our products these authorities must approve these products and our manufacturing processes and facilities. As our facilities grow, we may become subject to additional regulation or higher compliance standards. We are also subject to ongoing reviews of our products and manufacturing processes. For example, formaldehyde is an extensively regulated chemical, which various public health agencies continue to

 

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evaluate. The International Agency for Research on Cancer, or IARC, has recently reclassified formaldehyde as “carcinogenic to humans,” a higher classification than previous IARC evaluations, based principally on a study conducted by the National Cancer Institute (NCI) linking formaldehyde exposure to nasopharyngeal cancer, a rare form of cancer in humans. IARC also concluded that there was strong but not sufficient evidence for a finding of a causal association between leukemia and occupational exposure to formaldehyde, although IARC could not identify a mechanism for leukemia induction. IARC’s monograph reporting this decision has not yet been published. It is possible that this reclassification will lead to further governmental review of existing regulations and may result in additional costly requirements. In addition, BPA, which is used as an intermediate at our Deer Park and Pernis manufacturing facilities and is also sold directly to third parties, is currently under evaluation as an “endocrine disrupter.” Endocrine disrupters are chemicals that have been alleged to interact with the endocrine systems of humans and wildlife and disrupt normal processes. Pursuant to EU regulation 793/93/EC, BPA producers are currently conducting an extensive toxicology testing program of the chemical. In the event that BPA is further regulated, additional operating costs would likely be incurred to meet more stringent regulation of the chemical.

 

In order to obtain regulatory approval of certain new products, we must, among other things, demonstrate to the relevant authority that the product is safe for its intended uses and that we are capable of manufacturing the product in accordance with current regulations. The process of seeking approvals can be costly, time consuming and subject to unanticipated and significant delays. Approvals may not be granted to us on a timely basis, or at all. Any delay in obtaining, or any failure to obtain or maintain, these approvals would adversely affect our ability to introduce new products and to generate revenue from those products. New laws and regulations may be introduced in the future that could result in additional compliance costs, seizures, confiscation, recall or monetary fines, any of which could prevent or inhibit the development, distribution or sale of our products. For example, we produce resin-coated sand. Because sand consists primarily of crystalline silica, it creates the potential for silica exposure, which is a recognized health hazard. The Occupational Safety and Health Administration, or OSHA, will likely propose in 2006 a comprehensive occupational health standard for crystalline silica to provide for lower permissible exposure limits, exposure monitoring, medical surveillance and worker training. We may have to incur substantial additional costs over time to comply with any new OSHA regulations. In addition, the European Commission is finalizing a new regulatory system, known as Registration, Evaluation and Authorization of Chemicals, or REACH, which would require manufacturers, importers and consumers of certain chemicals to register such chemicals and evaluate their potential impacts on human health and the environment. Based on the results of the evaluation, a newly created regulatory body would then determine if the chemical should be further tested, regulated, restricted or banned from use. If REACH is enacted in its current form, significant market restrictions could be imposed on the current and future uses of chemical products sold by us in the European Union. Because the timing and ultimate form of the potential REACH regulation is not yet known, we cannot accurately predict future compliance costs, which could be significant. If we fail to comply with applicable laws and regulations, we may be subject to civil remedies, including fines, injunctions, recalls or seizures, which would have an adverse effect on our financial condition, cash flows and profitability.

 

Because we manufacture and use materials that are known to be hazardous, our production facilities are subject to significant operating hazards which could cause personal injury and loss of life, severe damage to, or destruction of, property and equipment and environmental contamination.

 

We are dependent on the continued operation of our 86 production facilities. These facilities are subject to hazards associated with the manufacture, handling, storage and transportation of chemical materials and products, including pipeline leaks and ruptures, explosions, fires, inclement weather and natural disasters, mechanical failure, unscheduled downtime, labor difficulties, transportation interruptions, and environmental hazards, such as spills, discharges or releases of toxic or hazardous substances and gases, storage tank leaks and remediation complications. These hazards can cause personal injury and loss of life, severe damage to, or destruction of, property and equipment and environmental contamination and other environmental damage and

 

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could have a material adverse effect on our financial condition. In addition, due to the nature of our business operations, we have been and may continue to be subject to scrutiny from environmental action groups. For example, currently there is an environmental group in the vicinity of our Louisville facility led by residents of the “Rubbertown” area, in which there are many chemical facilities, including our plant. As is typical for such groups, residents are claiming that the chemical facilities have caused health and property damage. In addition, in another state, we have been named as a defendant in a lawsuit involving one of our divested facilities that alleges residents living nearby suffered health issues as a result of exposure to chemicals used at that plant. In addition, a group has challenged the use of toluene di-isocyanate (“TDI”) at our Môlndal, Sweden facility. As a result, a court has ruled that TDI use under the current permit must be reduced. Although we are appealing the court’s ruling, a limit on TDI use would restrict certain operations at that facility. The activities by the environmental groups could result in additional litigation and damage to our reputation. We may incur losses beyond the limits of, or outside the coverage of, our insurance policies, in particular for liabilities associated with environmental cleanup that may arise out of such hazards. In addition, from time to time, various types of insurance for companies in the chemical industry, such as coverage for silica claims, have not been available on commercially acceptable terms, or, in some cases, have been unavailable. In the future, we may not be able to obtain coverage at current levels, and our premiums may increase significantly on coverage that we maintain.

 

We are subject to adverse claims from our customers and their employees as a result of the hazardous nature of our products.

 

We produce hazardous chemicals that require appropriate procedures and care to be used in handling them or using them to manufacture other products. As a result of the hazardous nature of some of the products we use and produce, we may face exposure relating to incidents involving our customers’ improper handling, storage and use of our products. On February 20, 2003, an explosion occurred at the facility of one of our customers, CTA Acoustics, Inc., which we refer to as CTA. Seven plant workers were killed and more than 40 workers were injured. There are six lawsuits in Laurel County, Kentucky, arising out of this incident, primarily seeking recovery for wrongful death, personal injury, emotional distress, loss of consortium, property damage and indemnity. On October 20, 2005, a settlement was reached with representatives of seven deceased plant workers and twelve seriously injured workers. Our proposed share of the settlement amount is expected to be covered by insurance. The property damage claim and suits by workers for emotional distress and minor injuries remain to be resolved. Although we believe that we have adequate insurance coverage to address any additional payments and/or legal fees in excess of $5 million involved in any single incident, we could be subject to additional significant judgments given the nature of this litigation. We have historically faced a substantial number of lawsuits, including class action lawsuits, claiming liability for death, injury or property damage caused by products we manufacture or those that contain our components. These lawsuits, and any future lawsuits, could result in substantial damage awards against us, which in turn could encourage additional lawsuits. The classification of formaldehyde as “carcinogenic to humans” by IARC could become the basis in product liability litigation, particularly if there are any definitive studies demonstrating a causal association with leukemia. In addition, in large part as a result of the bankruptcies of many producers of asbestos containing products, plaintiffs’ attorneys are increasing their focus on peripheral defendants, including us, and asserting that even products that contained a small amount of asbestos caused injury. Plaintiffs’ attorneys are also focusing on alleged harm caused by other products we have made or used, including silica-containing resin coated sands and vinyl chloride monomer, or VCM. While we cannot predict the outcome of pending suits and claims, we believe that we have adequate reserves to address currently pending litigation and adequate insurance to cover currently pending and foreseeable future claims. An unfavorable outcome in these litigation matters may cause our profitability, business, financial condition and reputation to decline.

 

Our substantial international operations subject us to risks not faced by domestic competitors, which include unfavorable political, regulatory, labor and tax conditions in other countries.

 

We have significant manufacturing operations outside the United States. In 2005, our net sales outside the United States represented approximately 50% of our total sales. We have 49 production facilities located outside the United States, primarily concentrated in Australia, Brazil, Canada, China, the Czech Republic,

 

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Germany, Italy, Korea, Malaysia, the Netherlands and the United Kingdom. Accordingly, our business is subject to the differing legal, political, social and regulatory requirements and economic conditions of many jurisdictions. Risks are inherent in international operations, including, but not limited to, the following:

 

    difficulty in enforcing agreements through foreign legal systems;

 

    foreign customers may have longer payment cycles;

 

    foreign countries may impose additional withholding taxes or otherwise tax our foreign income, impose tariffs or adopt other restrictions on foreign trade and investment, including currency exchange controls;

 

    fluctuations in exchange rates may affect product demand and may adversely affect the profitability in U.S. dollars of products and services provided by us in foreign markets where payment for our products and services is made in the local currency;

 

    increased costs of transportation or shipping;

 

    risk of nationalization of private enterprises;

 

    changes in general economic and political conditions in the countries in which we operate;

 

    unexpected adverse changes in foreign laws or regulatory requirements, including those with respect to environmental protection, export duties and quotas;

 

    difficulty with staffing and managing widespread operations; and

 

    required compliance with a variety of foreign laws and regulations.

 

In addition, intellectual property rights may be more difficult to enforce in foreign countries. We currently have joint ventures in China, where we license technology to our joint venture partners. We may not be able to adequately protect our intellectual property in China or elsewhere. Our business in emerging markets requires us to respond to rapid changes in market conditions in these countries. Our overall success as a global business depends, in part, upon our ability to succeed in differing legal, regulatory, economic, social and political conditions. We may not continue to succeed in developing and implementing policies and strategies that will be effective in each location where we do business. Furthermore, each of the foregoing risks is likely to take on increased significance as we implement our plans to expand our foreign operations.

 

Currency translation risk and currency transaction risk may negatively affect our net sales, cost of sales and operating margins and could result in exchange losses.

 

We conduct our business and incur costs in the local currency of most countries in which we operate. In 2005, our net sales outside the United States represented approximately 50% of our total sales. Accordingly, our results of operations are reported in the relevant local currency and then translated to U.S. dollars at the applicable currency exchange rate for inclusion in our financial statements. Changes in exchange rates between those foreign currencies and the U.S. dollar will affect our net sales, cost of sales and operating margins and could result in exchange losses. In addition to currency translation risks, we incur currency transaction risk whenever one of our operating subsidiaries enters into either a purchase or a sales transaction using a different currency from the currency in which it receives revenues. In an effort to mitigate the impact of exchange rate fluctuations we engage in exchange rate hedging activities. However, the hedging transactions we enter into may not be effective or could result in foreign exchange hedging loss. The impact of future exchange rate fluctuations on our results of operations cannot be accurately predicted. Given the volatility of exchange rates, we may not be able to effectively manage our currency transaction and/or translation risks, and any volatility in currency exchange rates may have an adverse effect on our financial condition, cash flows and profitability.

 

We operate our business in countries that historically have been and may continue to be susceptible to recessions or currency devaluation, including Brazil and Malaysia. In addition, as we expand our business in emerging markets, particularly China and Russia, the uncertain regulatory environment relating to currency policy in these countries could have a negative impact on our operations there.

 

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Failure to develop new products will make us less competitive.

 

Our results of operations depend to a significant extent on our ability to expand our product offerings, and to continue to develop our production processes to be a competitive producer. We are committed to remaining a competitive producer and believe that our portfolio of new or re-engineered products is strong. However, we may not be able to continue to develop new products, re-engineer our existing products successfully or bring them to market in a timely manner. For example, our historical research and development efforts generally have focused on customer service, and we may be unsuccessful in shifting our focus to the type of research that will lead to significant new product development. In addition, some of our research and development scientists are located at our individual plants rather than at a research facility, which may impede their ability to share ideas and create new products. While we believe that the products, pricing and services we offer customers are competitive, we may not be able to continue to attract and retain customers to which to sell our products.

 

We face competition from other chemical companies, which could force us to lower our prices, thereby adversely affecting our operating margins, financial condition, cash flows and profitability.

 

The markets in which we operate are highly competitive, and this competition could harm our business, results of operations, cash flow and financial condition. Our competitors include major international producers as well as smaller regional competitors. We believe that the most significant competitive factor for our products is selling price and we may be forced to lower our selling price based on our competitors’ pricing decisions, thereby reducing our profitability. In addition, current and anticipated future consolidation among our competitors and customers may cause us to lose market share as well as put downward pressure on pricing. Furthermore, there is a trend in the chemical industry toward relocation of manufacturing facilities to lower-cost regions such as Asia. Such relocation may permit some of our competitors to lower their costs and improve their competitive position. Some of our competitors are larger, have greater financial resources and have less debt than we do. As a result, those competitors may be better able to withstand a change in conditions within our industry and throughout the economy as a whole. If we do not compete successfully, our business, operating margins, financial condition, cash flows and profitability could be adversely affected.

 

Competition from producers of materials that are substitutes for formaldehyde-based resins could lead to declines in our net sales attributable to these products.

 

We face competition from a number of products that are potential substitutes for formaldehyde-based resins. Currently, we estimate that formaldehyde-based resins make up most of the resins used as panelboard resins, wood and specialty adhesives and industrial resins. Decreases in the average selling price of formaldehyde may cause our profitability to decline. For example, competition among producers of foundry and specialty resins has led to erosion in certain product prices in the past. Our ability to maintain or increase our profitability will continue to be dependent, in large part, upon our ability to offset decreases in average selling prices by improving production efficiency or by shifting to higher margin chemical products. In addition, in some markets, non-formaldehyde based resins may be an alternative to our formaldehyde-based resins. Considerable growth in these substitutes for formaldehyde-based resins could adversely affect our market share, net sales and profit margins. Furthermore, the movement towards substitute products could be exacerbated as a result of the IARC recent reclassification of formaldehyde from a “probable human carcinogen” to “carcinogenic to humans” based on studies linking formaldehyde exposure to nasopharyngeal cancer, and a possible causal association between leukemia and occupational exposure to formaldehyde.

 

Acquisitions and joint ventures that we pursue may present unforeseen integration obstacles and costs, increase our leverage and negatively impact our performance.

 

We have made acquisitions of related businesses, and entered into joint ventures in the recent past and intend to selectively pursue acquisitions of, and joint ventures with, related businesses as one element of our growth strategy. We are evaluating several potential tuck-in acquisitions and are in various stages of due diligence and

 

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negotiations with respect thereto. These transactions may not be consummated in the foreseeable future, if at all, and we may not consummate significant acquisitions in the future. We may, in the future, pursue acquisitions of a significantly larger scale than in the past. If such acquisitions are consummated, the risk factors we describe below, and for our business generally, may be intensified.

 

Our ability to implement our growth strategy is limited by covenants in our senior secured credit facilities and indentures, our financial resources, including available cash and borrowing capacity, and our ability to integrate or identify appropriate acquisition and joint venture candidates. Moreover, acquisitions of businesses may require us to assume or incur additional debt financing, resulting in additional leverage and complex debt structures.

 

The expense incurred in consummating acquisitions of related businesses, or our failure to integrate such businesses successfully into our existing businesses, could result in our incurring unanticipated expenses and losses. Furthermore, we may not be able to realize any anticipated benefits from acquisitions or joint ventures. The process of integrating acquired operations into our existing operations may result in unforeseen operating difficulties and may require significant financial resources that would otherwise be available for the ongoing development or expansion of existing operations. Some of the risks associated with our acquisition and joint venture strategy include:

 

    potential disruption of our ongoing business and distraction of management;

 

    unexpected loss of key employees or customers of the acquired company;

 

    conforming the acquired company’s standards, processes, procedures and controls with our operations;

 

    coordinating new product and process development;

 

    hiring additional management and other critical personnel; and

 

    increasing the scope, geographic diversity and complexity of our operations.

 

In addition, we may encounter unforeseen obstacles or costs in the integration of acquired businesses. For example, the preparation of the US GAAP financial statements for Bakelite required significant management resources. Also, the presence of one or more material liabilities of an acquired company that are unknown to us at the time of acquisition may have a material adverse effect on our business. Our acquisition and joint venture strategy may not be successfully received by customers, and we may not realize any anticipated benefits from acquisitions or joint ventures.

 

Our future success depends on our ability to retain our key employees.

 

We are dependent on the services of Craig O. Morrison, our President and Chief Executive Officer, William H. Carter, our Chief Financial Officer and other members of our senior management team, who collectively have over 140 years of experience in the chemical and plastics industries, to remain competitive in our industry. The loss of Mr. Morrison or any other member of our senior management team could have an adverse effect on us. There is a risk that we will not be able to retain or replace these key employees. All of our current key employees are subject to employment conditions or arrangements that contain post employment non-competition provisions. However, these arrangements permit the employees to terminate their employment with little or no notice.

 

We may be required to expend greater time and expense than other companies in dealing with our employees, some of whom are unionized, represented by workers’ councils or are employed subject to local laws that are less favorable to employers than the laws of the United States.

 

As of December 31, 2005, approximately 46% of our employees were unionized or represented by workers’ councils that have collective bargaining agreements. In addition, some of our employees are employed in countries in which employment laws provide greater bargaining or other rights to employees than the laws of the United States. Such favorable employment rights require us to expend greater time and expense in making

 

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changes to employees’ terms of employment or making staff reductions. For example, most of our employees in Europe are represented by workers’ councils which must approve any changes in conditions of employment, including salaries and benefits. “Protection against dismissal” claims have been brought by certain of such workers’ councils in connection with Bakelite’s cost-saving initiatives. A significant dispute with our employees may divert management’s attention and otherwise hinder our ability to conduct our business and achieve planned cost savings.

 

We rely on patents and confidentiality agreements to protect our intellectual property. Our failure to protect our intellectual property rights could adversely affect our future performance and growth.

 

Protection of our proprietary processes, methods and compounds and other technology is important to our business. Failure to protect our existing intellectual property rights may result in the loss of valuable technologies or having to pay other companies for infringing on their intellectual property rights. We rely on patent, trade secret, trademark and copyright law as well as judicial enforcement to protect such technologies. A majority of our patents relate to the development of new products and processes for manufacturing and use thereof and expire at various times between 2006 and 2026. Some of our technologies are not covered by any patent or patent application. In addition, our patents could be challenged, invalidated, circumvented or rendered unenforceable. Furthermore, pending patent applications may not result in an issued patent, or if patents are issued to us, such patents may not provide meaningful protection against competitors or against competitive technologies.

 

Our production processes and products are specialized. However, we could face patent infringement claims from our competitors or others alleging that our processes or products infringe on their proprietary technology. If we were subject to an infringement suit, we may be required to change our processes or products or stop using certain technologies or producing the infringing product entirely. Even if we ultimately prevail in an infringement suit, the existence of the suit could cause our customers to seek other products that are not subject to infringement suits. Any infringement suit could result in significant legal costs and damages and impede our ability to produce key products, which could have a material adverse effect on our business, financial condition and results of operations.

 

In addition, effective patent, trademark, copyright and trade secret protection may be unavailable or limited in some foreign countries. In some countries we do not apply for patent, trademark or copyright protection. We also rely upon unpatented proprietary manufacturing expertise, continuing technological innovation and other trade secrets to develop and maintain our competitive position. While we generally enter into confidentiality agreements with our employees and third parties to protect our intellectual property, such confidentiality agreements are limited in duration and could be breached, and may not provide meaningful protection for our trade secrets or proprietary manufacturing expertise. Adequate remedies may not be available in the event of an unauthorized use or disclosure of our trade secrets and manufacturing expertise. In addition, others may obtain knowledge of our trade secrets through independent development or other access by legal means. The failure of our patents or confidentiality agreements to protect our processes, apparatuses, technology, trade secrets and proprietary manufacturing expertise, methods and compounds could have an adverse effect on our business by jeopardizing critical intellectual property.

 

If we are unable to access funds generated by our subsidiaries we may not be able to meet our financial obligations.

 

Because Hexion conducts many of its operations through its subsidiaries, Hexion depends on those entities for dividends, distributions and other payments to generate the funds necessary to meet its financial obligations. Legal and contractual restrictions in certain agreements governing current and future indebtedness of Hexion’s subsidiaries, as well as the financial condition and operating requirements of Hexion’s subsidiaries, may limit Hexion’s ability to obtain cash from its subsidiaries. All of Hexion’s subsidiaries are separate and independent legal entities and have no obligation whatsoever to pay any dividends, distributions or other payments to Hexion.

 

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Significant changes in pension fund investment performance or assumptions relating to pension costs may increase the valuation of pension obligations, alter the funded status of pension plans and increase our pension costs.

 

Our funding policy for pension plans is to accumulate plan assets that, over the long run, will approximate the present value of projected benefit obligations. Our pension cost is materially affected by the discount rate used to measure pension obligations, the level of plan assets available to fund those obligations at the measurement date and the expected long-term rate of return on plan assets. Significant changes in investment performance or a change in the portfolio mix of invested assets can result in corresponding increases and decreases in the valuation of plan assets, particularly equity securities, or in a change of the expected rate of return on plan assets. A change in the discount rate would result in a significant increase or decrease in the valuation of pension obligations, affecting the reported funded status of our pension plans as well as the net periodic pension cost in the following financial years. Similarly, changes in the expected return on plan assets assumption can result in significant changes in the net periodic pension cost of the following financial years.

 

One of the Company’s pension plans is currently underfunded and we may have to make significant cash payments to the plan and/or incur a liability to the Pension Benefit Guaranty Corporation. Termination by the Pension Benefit Guaranty Corporation would further increase our pension expense and could result in liens on material amounts of our assets.

 

On April 14, 2005, the Company notified the Pension Benefit Guaranty Corporation, or PBGC, that a legacy Borden Chemical defined benefit pension plan (the “Borden Plan”) was underfunded by approximately $104 million on a termination basis. IRS regulations require us to increase our contributions to the Borden Plan to reduce this underfunding. Based on current IRS regulations and plan provisions, we expect that our total minimum funding requirements for the five years ended in 2010 for the Borden Plan will be approximately $55 million. If the performance of the assets in the Borden Plan does not meet our expectations, if the PBGC requires additional contributions to the Borden Plan as a result of the Hexion Formation if there are changes to IRS regulations or other applicable law, or if other actuarial assumptions are modified, our contributions for those years could be higher than we expect.

 

The need to make these cash contributions may reduce the cash available to meet our other obligations or to meet the needs of our business. In addition, the PBGC may terminate the Borden Plan under limited circumstances, including in the event the PBGC concludes that its risk may increase unreasonably if the Borden Plan continues. In the event the Borden Plan is terminated for any reason while it is underfunded, we could be required to make an immediate payment to the PBGC of all or a substantial portion of the Borden Plan’s underfunding, as calculated by the PBGC based on its own assumptions (which might result in a larger pension obligation than that based on the assumptions we have used to fund the Borden Plan), and the PBGC could assert a lien on material amounts of our assets.

 

In addition, in 2003, the IRS notified the Company that cash balance plans such as the Borden Plan may be required to be amended because of recent ERISA rulings that found cash balance plans to be discriminatory. The IRS indicated that the Borden Plan should continue to operate as currently designed until new guidance is available. Although the effect of any future guidance is not known, it is possible that such guidance may increase our obligations under the Borden Plan.

 

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Our equity sponsor controls us and its interests may conflict with or differ from your interests.

 

Apollo beneficially owns approximately 91% of our common stock. In addition, representatives of Apollo have the ability to prevent any transaction that requires the approval of directors. As a result, Apollo has the ability to substantially influence all matters requiring shareholder approval, including the election of our directors and the approval of significant corporate transactions such as mergers, tender offers and the sale of all or substantially all of our assets. The interests of Apollo and its affiliates could conflict with or differ from your interests. For example, the concentration of ownership held by Apollo could delay, defer or prevent a change of control of our company or impede a merger, takeover or other business combination, which you may otherwise view favorably. Apollo may also pursue acquisition opportunities that may be complementary to our business, and as a result, those acquisition opportunities may not be available to us. A sale of a substantial number of shares of stock in the future by funds affiliated with our equity sponsor could cause our stock price to decline in the future.

 

Our internal control over financial reporting may not be effective and our independent auditors may not be able to certify as to their effectiveness, which could have a significant and adverse effect on our business and reputation.

 

We will be subject to the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 and the rules and regulations of the SEC thereunder (which we refer to as Section 404) as of December 31, 2007. Section 404 requires us to report on, and our independent auditors to attest to, the design and effectiveness of our internal control over financial reporting. Prior to the Combinations, Borden Chemical and Resolution Performance had performed the system and process evaluation in an effort to comply with management certification and auditor attestation requirements of Section 404. However, prior to the Combinations, Bakelite and Resolution Specialty were not required to meet these regulations. In the course of our ongoing Section 404 evaluation, we have identified areas of internal controls that need improvement.

 

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For example, Bakelite’s original system of financial reporting was designed to comply with German GAAP; accordingly, Bakelite’s management determined that Bakelite did not have sufficient internal controls and resources relating to the preparation of US GAAP financial statements. As Resolution Specialty began the process of developing a stand-alone infrastructure, Resolution Specialty’s management determined that Resolution Specialty did not have sufficient internal controls and resources relating to the preparation of US GAAP financial statements. In addition, as our international operations have expanded and the complexity of our business has increased, we have determined that, in some instances, local resources are not adequately familiar with US GAAP areas such as income tax accounting. As a result of such determinations, we have utilized additional outside advisors, as appropriate, to assess and to assist with the US GAAP closing and consolidation processes associated with preparing the financial statements included herein, including the conversion of local and German GAAP to US GAAP. While we have added additional resources to assist with the US GAAP closing, tax accounting and consolidation processes, for future reporting periods, such closing and consolidation processes may result in delays in reporting our results.

 

In order to improve our internal controls, we have changed and expanded the roles and responsibilities of key personnel and made changes to certain processes related to financial reporting. As part of the integration of Resolution Specialty and Resolution Performance, we continue the process of consolidating some of the transaction processing and general accounting activities of Resolution Specialty, and Resolution Performance to a lesser extent, into a common shared services transaction processing environment with the Corporate and North American activity related to the former Borden Chemical operation. We have also recently launched a project to consolidate multiple legacy systems and multiple SAP® systems. Once fully implemented, this change to a shared services business model (for certain processes) along with a single SAP® system is intended to further enhance our internal control over financial reporting and our operating efficiencies. We have also expanded the scope of the services of the international accounting firm that provides tax accounting and compliance services and support to include Resolution Performance, Resolution Specialty and Bakelite. Management has also added additional tax personnel to assist current personnel in monitoring the tax reporting process and continues to evaluate the need for additional tax, US GAAP and financial reporting resource needs based on the Combinations and recent acquisitions.

 

However, as the evaluation process is ongoing, we may identify additional conditions that may be categorized as areas of internal control that need improvement in the future. We cannot be certain as to the timing of completion of our evaluation, documentation, testing and any remediation actions or the impact of the same on our operations. If our remediation actions described above are insufficient and we are not able to obtain reports or institute controls on a timely basis, the chief financial officer or chief executive officer may conclude that our controls are ineffective for purposes of Section 404, our independent auditors may conclude that our assessment process or our internal control over financial reporting were not effective. As a result, there could be a negative reaction in the financial markets due to a loss of confidence in the reliability of our financial statements or our financial statements could change. In addition, we may be required to incur costs in improving our internal control system and the hiring of additional personnel. Any such action could negatively affect our results of operations.

 

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ITEM 1B. UNRESOLVED STAFF COMMENTS

 

None.

 

ITEM 2. PROPERTIES

 

As of December 31, 2005, we operated 37 domestic production and manufacturing facilities in 19 states. In addition, we operated 49 foreign production and manufacturing facilities primarily in Australia, Brazil, Canada, the Czech Republic, China, Germany, Italy, Korea, Malaysia, the Netherlands, Spain and the United Kingdom. Our production and manufacturing facilities are generally well-maintained and effectively utilized. We believe our production and manufacturing facilities are adequate to operate our business.

 

The majority of our facilities are used for the production of thermosetting resins, and most of our facilities produce more than one type of thermoset resin. The resins produced vary by site, but include all of our technologies: amino resins (urea and melamine), phenolic resins, epoxy resins, alkyd resins, polyester resins, acrylic resins, urethane resins, ink resins, composite resins, powder resins, versatic derivatives and U/V resins. These facilities typically utilize batch technology, and range in size from small sites with a limited number of reactors to larger, core sites with dozens of reactors. Two exceptions to this are the plants in Solbiate, Italy and Deer Park, Texas (the only “continuous” process epoxy resins plant in the world), which provide us with a cost advantage over conventional technology.

 

In addition, we have the ability to internally produce key intermediate materials such as formaldehyde, BPA, ECH, versatic acid, acrylic acid and gum rosin. This provides us with a competitive cost advantage relative to our competitors and facilitates our adequacy of supply. These facilities are usually co-located with the thermoset resin facilities they serve, and the process technology utilized in the production process is generally more complicated. These intermediate materials facilities are often much larger than a typical resins plant, in order to capture the benefits of manufacturing efficiency and scale; as a result, these facilities typically also have the ability to sell material not used internally to third parties.

 

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We are headquartered in Columbus, Ohio and our major manufacturing facilities are primarily located in North America and Europe. Our more significant production and manufacturing facilities include:

 

Location


 

Nature of Ownership


 

Reporting Segment


Pernis, The Netherlands*   Owned   Epoxy and Phenolic Resins

Duisburg-Meiderich,

Germany

  Owned/Leased   Epoxy and Phenolic Resins
Deer Park, TX   Owned   Epoxy and Phenolic Resins

Iserlohn-Letmathe,

Germany

  Owned/Leased   Epoxy and Phenolic Resins
Norco, LA*   Owned   Epoxy and Phenolic Resins
Louisville, KY   Owned   Epoxy and Phenolic Resins
Sokolov, Czech Republic   Owned   Coatings and Inks
Edmonton, AB, Canada   Owned   Formaldehyde and Forest Products
Gonzales, LA   Owned   Formaldehyde and Forest Products
Kitee, Finland   Owned   Formaldehyde and Forest Products
Geismar, LA   Owned   Formaldehyde and Forest Products
Lakeland, FL   Owned   Epoxy and Phenolic Resins
Brady, TX   Owned   Performance Products

  * All of the assets at this facility are owned. The land is occupied pursuant to a ground lease.

 

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ITEM 3. LEGAL PROCEEDINGS

 

Legal Proceedings

 

Environmental Proceedings. We have recorded liabilities of approximately $39 million relating to 69 locations at December 31, 2005 for all probable environmental remediation, indemnification and restoration liabilities. At December 31, 2004, we recorded liabilities of approximately $41 million relating to 63 locations for all probable environmental remediation, indemnification and restoration liabilities. These locations include existing and former manufacturing locations, as well as third-party disposal or Superfund sites where we have been named a potentially responsible party.

 

The Sokolov, Czech Republic facility has soil and groundwater contamination which pre-dates privatization and acquisition of the facility by Eastman in 2000. The investigation phase of a site remediation project is underway, directed by a steering committee which includes the Company, the National Property Fund and local regulators. The National Property Fund has provided its written commitment to reimburse all site investigation and remediation costs up to approximately $73 million. The current estimate for known site remediation is $16 million, but may increase following additional site investigation.

 

On August 8, 2005, Governo Do Parana and the Environmental Institution of Paraná IAP, an environmental agency of the Brazilian government, provided Borden Quimica Industrias, our Brazilian subsidiary, with notice of a potential fine of up to $5.4 million in connection with alleged environmental damages to the Port of Paranagua caused in November 2004 by an oil spill by a shipping vessel carrying methanol purchased by Hexion. The investigation is ongoing and no final determination has been made with respect to damages or the liability of our Brazilian subsidiary. We are disputing this claim.

 

We have entered into environmental indemnification agreements with each of the sellers in the Bakelite Transaction, Resolution Performance Transaction and Resolution Specialty Transaction. Under the Bakelite environmental indemnification agreement, the sellers have agreed to indemnify us for certain pre-existing environmental liabilities, including those related to our facility in Duisburg, Germany. Under the Resolution Performance environmental indemnification agreement, Shell will generally remain liable for pre-existing environmental conditions at facilities that were transferred to us in connection with the Resolution Performance Transaction and, under the Resolution Specialty environmental indemnification agreement, Eastman generally

 

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will remain liable for pre-existing unknown environmental conditions at facilities that were transferred to us in connection with the Resolution Specialty Transaction, as well as the pre-existing known environmental conditions at the Roebuck, South Carolina facility. The indemnities under each of these agreements are subject to certain exceptions and limitations. In addition, our claims under each of the environmental indemnity agreements are subject to deductibles, ranging from $0.1 million for the Resolution Specialty agreement to € 1 million for certain claims under the Bakelite agreement, and indemnity caps, ranging from $10 million for certain liabilities under the Resolution Performance agreement to € 275 million for certain liabilities under the Bakelite agreement.

 

Other Legal Proceedings. We are involved in various product liability, commercial litigation, personal injury, property damage and other legal proceedings which are considered to be in the ordinary course of our business. In large part, as a result of the bankruptcies of many asbestos producers, plaintiff’s attorneys are increasing their focus on peripheral defendants, including us, and asserting that even products that contained a small amount of asbestos caused injury. Plaintiffs are also focusing on alleged harm caused by other products we have made or used, including those containing silica and vinyl chloride monomer. We believe we have adequate reserves and insurance to cover currently pending and foreseeable future claims.

 

We have reserved approximately $12 million at December 31, 2005 relating to all non-environmental legal matters for legal defense and settlement costs that we believe are probable and estimable at this time. At December 31, 2004, we reserved approximately $21 million relating to all non-environmental legal matters for legal defense and settlement costs which were believed to be probable and estimable at this time.

 

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ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

During the fourth quarter, no matters were submitted to a vote of security holders.

 

PART II

 

ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

 

There is no established public trading market for our common stock. As of March 1, 2006, 82,629,906 common shares were held by our parent, Hexion LLC.

 

We do not currently intend to pay any cash dividends on our common stock, and instead intend to retain earnings, if any, for future operations and debt reduction. Our senior secured credit facilities and the indentures governing our notes impose restrictions on our ability to pay dividends, and thus our ability to pay dividends on our common stock will depend upon, among other things, our level of indebtedness at the time of the proposed dividend and whether we are in default under any of our debt instruments. Our future dividend policy will also depend on the requirements of any future financing agreements to which we may be a party and other factors considered relevant by our board of directors. Any decision to declare and pay dividends in the future will be made at the discretion of our board of directors and will depend on, among other things, our results of operations, cash requirements, financial condition, business opportunities, provision of applicable law and other factors that our board of directors may deem relevant. For a discussion of our cash resources and needs, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources.”

 

On May 31, 2005, we used all of the proceeds that we received from the offering of shares of our Series A Preferred Stock and a portion of the proceeds from borrowings under our senior secured credit facilities to declare a special dividend of approximately $550 million (of which $27 million remains to be paid) to our parent, Hexion LLC, which in turn paid a pro rata special dividend to its equity holders, which included Apollo and other investors, including certain members of our management.

 

We have no compensation plans that authorize the issuance of our stock to employees or non-employees. There have been no sales or repurchases of our equity securities during the past fiscal year.

 

ITEM 6. SELECTED FINANCIAL DATA

 

Five Year Selected Consolidated Financial Data

 

The following summarizes our selected financial data for the past five years. See Results of Operations in Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations for items impacting comparability between 2005, 2004 and 2003.

 

(In millions, except share and per share data)

                   

For the years


   (1) 2005

    (2) 2004

    (3) 2003

    (3) 2002

    (3) 2001

 

Summary of Earnings

                                        

Net sales

   $ 4,470     $ 2,019     $ 782     $ 740     $ 863  

Loss from continuing operations

     (78 )     (105 )     (50 )     (11 )     (5 )

Net loss applicable to common shareholders

     (117 )     (105 )     (50 )     (11 )     (5 )

Basic and diluted loss per common share from continuing operations

   $ (1.30 )   $ (1.27 )   $ (0.61 )   $ (0.13 )   $ (0.06 )

Basic and diluted (loss) income per common share

     (1.41 )     (1.27 )   $ (0.61 )     (0.13 )     (0.06 )

Dividends per share

                                        

Redeemable Series A Preferred Stock

   $ 6.66       —         —         —         —    

Average number of common shares outstanding during the period- basic and diluted

     82,629,906       82,629,906       82,629,906       82,629,906       82,629,906  

Financial Statistics

                                        

Total assets

   $ 3,209     $ 2,696     $ 1,191     $ 1,179     $ 1,101  

Long-term debt

   $ 2,303     $ 1,834     $ 675     $ 567     $ 581  

 

(1) Includes data for Bakelite from its date of acquisition, April 29, 2005. Results include $17 of writeoffs of deferred financing fees and $44 of Transaction costs.

 

(2) Includes data for Resolution Specialty from August 2, 2004 and for Borden Chemical from August 12, 2004, their respective dates of acquisition by Apollo. Results include $56 of Transaction costs.

 

(3) Includes results of Resolution Performance only.

 

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

(Dollars in millions)

 

Forward-Looking and Cautionary Statements

 

Certain statements in this annual report on Form 10-K, including without limitation, statements made under the captions “Overview” and “Outlook,” are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended. In addition, the management of Hexion Specialty Chemicals, Inc. (which may be referred to as “Hexion,” “we,” “us,” “our” or the “Company”) may from time to time make oral forward-looking statements. Forward looking statements may be identified by the words “believe,” “expect,” “anticipate,” “project,” “plan,” “estimate,” “will” or “intend” and similar expressions. The forward-looking statements contained herein reflect our current views with respect to future events and are based on our currently available financial, economic and competitive data and on current business plans. Actual results could vary materially depending on risks and uncertainties that may affect the Company’s operations, markets, services, prices and other factors as discussed herein in Item 1A—Risk Factors. Important factors that could cause actual results to differ materially from those in the forward-looking statements include, but are not limited to: economic factors such as an interruption in the supply of or increased pricing of raw materials due to natural disasters, competitive factors such as pricing actions by our competitors that could affect our operating margins, and regulatory factors such as changes in governmental regulations involving our products that lead to environmental and legal matters as described herein in Item 3. Legal Proceedings.

 

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Overview

 

We are the world’s largest producer of thermosetting resins, or thermosets. Thermosets are a critical ingredient for virtually all paints, coatings, glues and other adhesives produced for consumer or industrial uses. We are focused on providing a broad array of thermosets and associated technologies, with leading market positions in all key markets served.

 

The total global thermoset resins market is approximately $34 billion in annual sales, of which our primary markets represent approximately $19 billion in annual sales.

 

Our products are used in thousands of applications and are sold into diverse markets, such as forest products, architectural and industrial paints, packaging, consumer products and automotive coatings, as well as higher growth markets, such as composites, UV cured coatings and electrical laminates. As of December 31, 2005, we had 86 production sites globally and produce many of our key products locally in North America, Latin America, Europe and Asia. Through our worldwide network of strategically located production facilities, we serve more than 10,000 customers in 100 countries. We believe our global scale provides us with significant advantages over many of our competitors. In areas where it is advantageous, we are able to internally produce strategic raw materials, providing us with a lower cost operating structure and security of supply. In other areas, where we can capitalize on our technical know-how and market presence to capture additional value, we are integrated downstream into product formulations. Our position in certain additives, complementary materials and services further enables us to leverage our core thermoset technologies and provide customers a broad range of product solutions. Our global customers include leading companies in their respective industries, such as 3M, Ainsworth, Ashland Chemical, BASF, Bayer, DuPont, GE, Halliburton, Honeywell, Huntsman, Louisiana Pacific Owens Corning, PPG Industries, Sumitomo, Sun Chemicals, Valspar and Weyerhaeuser.

 

Our organizational structure is based on the products we offer and the markets we serve. During the fourth quarter of 2005, we changed our reportable segments to better reflect the stage of the transition from the previous organization of our pre-merger companies to our organizational structure during the latter half of 2005. The transition provides greater alignment with the respective operating divisions and reporting segments. At December 31, 2005, our organizational structure consisted of four operating divisions: Epoxy and Phenolic Resins, Formaldehyde and Forest Products Resins, Coatings and Inks, and Performance Products. A brief summary of the operating divisions, which are aligned with the Company’s reportable segments, is as follows:

 

   

Epoxy and Phenolic Resins: Includes the operations primarily from the Resolution Performance and Bakelite legacy companies and the phenolic resins operation from the Borden Chemical legacy company. Major

 

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products include epoxy resins and intermediates, molding compounds, versatic acids and derivatives, specialty phenolic resins and epoxy coating resins.

    Formaldehyde and Forest Products Resins: Includes the formaldehyde and forest products operations primarily from the Borden Chemical legacy company. Major products include forest products resins and formaldehyde applications.
    Coatings and Inks: Includes the operations of the Resolution Specialty legacy company. Major products include composite resins, polyester resins, acrylic resins, alkyd resins, and ink resins and additives.
    Performance Products: Includes the oil field products and foundry applications operations from the Borden Chemical legacy company. Major products include phenolic encapsulated substrates for oil field services applications and foundry applications.

 

All historical segment information included herein has been restated to conform with our current segment reporting. The changes to previously reported segment information are simply a reclassification of activity among our segments and they do not impact any of our previously reported consolidated results.

 

We began implementing additional refinements to our operating divisions in 2006 to more closely link similar products, minimize divisional boundaries and improve our ability to serve common customers from pre-merger legacy company relationships which may result in additional refinements to our reporting segments.

 

Industry Conditions. As is true for many industries, our results are impacted by the effect on our customers of economic upturns or downturns, as well as the impact on our own costs to produce, sell and deliver our products. Our customers use most of our products in their production processes; therefore, factors impacting their industries could significantly affect our results.

 

Major industry sectors served by us include industrial/marine, construction, consumer/durable goods, automotive, electronics, architectural, civil engineering, repair/remodeling, graphic arts and oil and gas field support. Key drivers for our business are general economic and industrial growth, housing starts, auto builds, furniture demand, active gas drilling rigs, print advertising demand and chemical intermediates sector operating conditions.

 

After a relatively flat demand for our epoxy resins in 2002 and 2003, demand for our epoxy resins in 2004 increased significantly and demand through 2005 was strong. Similarly, the pricing environment for our epoxy resins was positively impacted by increased demand and lack of availability of raw materials in some segments of the market.

 

From 1997 to 2000, demand for bisphenol-A (“BPA”), a key precursor in the manufacture of epoxy resins, grew by approximately 13% per year driven primarily by the polycarbonate end-uses (electronics, computer, telecommunications and data equipment), whereas from 2000 to 2004, the average growth rate was approximately 6%. In 2004 there was a strong recovery in global BPA demand primarily driven by stronger production rates. Compared to 2003, the estimated demand growth has again approached 13%. More importantly, in the second half of 2004, the resulting tightness in supply and demand allowed for margin expansion despite the fact that the prices for phenol (BPA’s key feedstock) have seen significant increases in 2004. Global demand through 2005 was strong and we activated a previously idle reactor in 2005 to help meet this demand.

 

Raw Material Costs. Raw material costs make up approximately 80% of our product costs. In 2005, we purchased approximately $3 billion of raw materials. The three largest raw materials utilized in our production process are phenol, methanol and urea, which represents 49% of our total raw material expenditures. High energy costs such as the increasing price of crude oil and related petrochemical products and the higher cost of natural gas have translated into significant increases in raw material costs. For example, compared to the average prices in 2004, the average prices of phenol, methanol, and urea increased approximately 15%, 16% and 26%, respectively, in 2005. In

 

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2004 the average prices of phenol, methanol and urea increased by 48%, 7% and 19% respectively. To help mitigate this volatility, we have purchase and sale contracts with many of our vendors and customers with periodic price adjustment mechanisms. For example, in our North American forest products business, approximately 60% of our sales are to customers that have contracts that allow for the passing through of increases in raw material costs on average within 30 days. Due to differences in timing of the pricing mechanism trigger points between our sales and purchase contracts there is often a “lead-lag” impact during which margins are negatively impacted for the short term in periods of rising raw material prices and positively impacted in periods of falling raw material prices. In addition, the pass through of raw material price changes can result in significant variances in sales comparisons from year to year. In 2005 and 2004, we had a favorable impact on sales as raw material price increases throughout 2004 and 2005 were passed through to customers.

 

Phenol prices have risen in North America in the first quarter of 2006. In addition, methanol prices have risen in North America in the first quarter of 2006, and there are limited, if any, price reductions expected in the remainder of 2006. Urea prices are forecasted to remain high relative to historical levels in the long-term.

 

Regulatory Environment. National and international laws regulate the production and marketing of chemical substances. Although almost every country has its own legal procedure for registration and import, laws and regulations in the European Union and the United States are most significant to our business, including the European inventory of existing commercial chemical substances, the European list of notified chemical substances, and the United States Toxic Substances Control Act inventory. Chemicals which are on one or more of the above lists can usually be registered and imported without additional testing in other countries, although additional administrative hurdles may exist.

 

We are also subject to extensive regulation under the environmental and occupational health and safety laws by federal, state and local governmental entities and foreign authorities, such as the European Union. These laws are designed to protect workers and the public from exposure to certain hazardous chemicals and dangerous work conditions, to protect natural resources and to limit discharges of hazardous substances to the environment from ongoing operations. They provide for substantial fines and potential criminal sanctions for violations. They also establish requirements to remediate contamination. The laws are complex, change frequently and have tended to become more stringent over time.

 

For example, statutes such as the Federal Comprehensive Environmental Response, Compensation, and Liability Act and comparable state and foreign laws impose strict, joint and several liability for investigating and remediating the consequences of spills and other releases of hazardous materials, substances and wastes at current and former facilities, and at third-party disposal sites. Therefore, notwithstanding our commitment to environmental management, we cannot assure you that environmental, health and safety liabilities will not be incurred in the future, nor that such liabilities will not result in a material adverse effect on our financial condition, results of operations or business reputation.

 

Certain chemicals have been alleged to interact with the endocrine systems of humans and wildlife and disrupt normal processes (i.e., endocrine disrupters). BPA, which is used as an intermediate at our Deer Park and Pernis manufacturing facilities and is also sold directly to third parties, is currently under evaluation as an “endocrine disrupter.” Pursuant to EU regulation 793/93/EC, BPA producers are currently conducting an extensive toxicology testing program of the chemical. In addition, new legislation in Europe took effect in 2005 and requires that risk labels be used for BPA indicating “possible risk of impaired fertility.” In the event that BPA is further regulated, additional operating costs would likely be incurred to meet more stringent regulation of the chemical.

 

Various government agencies are conducting formaldehyde health assessments and evaluating the need for additional regulations. Although formaldehyde has been heavily regulated for several years, further regulation of

 

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formaldehyde could follow over time. In 2004, the International Agency for Research on Cancer (“IARC”) reclassified formaldehyde as “carcinogenic to humans,” a higher classification than previous IARC evaluations based principally on a study linking formaldehyde exposure to nasopharyngeal cancer, a rare form of cancer in humans. IARC also concluded that there was strong but not sufficient evidence for a finding, of an association between leukemia and occupational exposure to formaldehyde, although IARC could not identify a mechanism for leukemia induction. We believe that our production facilities will be able to comply with any likely regulatory impact without any material impact on the business.

 

We support appropriate scientific research and risk-based policy decision-making, and we are working with industry groups, including the Formaldehyde Council, Inc. (“FCI”), to ensure that governmental assessments and regulations are based on sound scientific information. As a part of that effort, the FCI is currently funding additional health research to supplement the existing science database. Results from some of this work will be available in 2006. We have leading product development technologies and processes and credible stewardship programs in place to provide compliant and cost-effective resin systems to our customers.

 

We also actively petition the U.S. Food and Drug Administration to sanction the use of certain specialty chemicals produced by us, principally where we believe that these specialty chemicals will or may be used by our customers in the manufacture of products that will come in direct or indirect contact with food. Delays in getting our product to the market may be incurred.

 

Competitive Environment. The chemical industry has been historically very competitive, and we expect this competitive environment to continue in the foreseeable future. We compete with companies of varying size, financial strength and availability of resources. Price, customer service and product performance are the primary areas in which we compete.

 

Impact of Hurricanes Katrina and Rita. During the third quarter of 2005, our operations in the Gulf Coast region of the United States were impacted by Hurricanes Katrina and Rita. Our Norco, LA and Deer Park, TX facilities incurred minimal damage from the hurricanes; however, the facilities were closed for 45 and 14 days after the hurricanes, respectively, due to repairs at facilities that provide us with utilities. Our facilities in the Gulf Coast escaped significant damage from Hurricane Rita, and though our facilities in the region were shut down in anticipation of Hurricane Rita, none remained closed for repair after the storm.

 

Our 2005 results were significantly impacted by the hurricanes as well. Approximately $27 of lost sales and incremental expenses associated with the hurricanes negatively impacted our operating income in the second half of 2005 of which $17 was incurred in the fourth quarter. These incremental expenses included higher cost of key raw materials, plant downtime, supply chain and other logistical disruptions and dislocated employees.

 

Other Factors Impacting Our Results. Other pressures on our profit margins include rising utility costs and increasing employee benefit, general insurance and legal costs. We are taking a number of steps to control these costs. In addition, we are continuing to analyze our business structure, consolidating plants and functions where we can realize significant cost savings and productivity gains. Future consolidations or productivity initiatives may include asset impairment charges and severance costs.

 

We believe that these factors will continue in the foreseeable future. These market dynamics will require us to continue to focus on productivity improvements and risk mitigation strategies to enhance and protect our margins. For a discussion of certain steps we are taking to manage factors impacting our margins through hedges of natural gas and foreign exchange exposures, see “—Quantitative and Qualitative Disclosure About Market Risk.”

 

Hexion Formation

 

The Combinations. On May 31, 2005, Resolution Performance and Resolution Specialty were combined with and into Borden Chemical (the “Combinations”), all of which were controlled by Apollo Management, L.P. and its affiliates (“Apollo”). In connection with the Combinations, the minority interests in Resolution Performance and Resolution Specialty were eliminated. Upon the consummation of the Combinations, Borden Chemical changed its name to Hexion Specialty Chemicals, Inc. and BHI Acquisition LLC, Borden Chemical’s parent, changed its name to Hexion LLC.

 

The Borden Transaction. On August 12, 2004, an affiliate of Apollo acquired all of the outstanding capital stock of Borden Chemical (the “Borden Acquisition”). The Borden Acquisition, the related offering of second-priority senior secured floating rate notes (the “Original Floating Rate Notes”) and 9% second-priority senior secured notes (the “Fixed Rate Notes”) and the related transactions are collectively referred to in this prospectus as the “Borden Transaction.”

 

The Resolution Performance Transaction. On November 14, 2000, an affiliate of Apollo acquired control of Resolution Performance in a recapitalization transaction (the “Resolution Performance Transaction”). Prior to the recapitalization, Resolution Performance was a wholly owned subsidiary of the Royal Dutch/Shell Group of Companies (“Shell”).

 

The Resolution Specialty Transaction. On August 2, 2004, Resolution Specialty, an affiliate of Apollo, acquired the resins, inks and monomers division (the “Resolution Specialty Acquisition”) of Eastman Chemical Company (“Eastman”). The Resolution Specialty Acquisition and the related transactions are collectively referred to in this prospectus as the “Resolution Specialty Transaction.”

 

The Bakelite Transaction. On April 29, 2005, a subsidiary of Borden Chemical acquired Bakelite (the “Bakelite Acquisition”). Upon the consummation of the Bakelite Acquisition, Bakelite became an indirect, wholly-owned subsidiary of Hexion Specialty Chemicals Canada, Inc. (“Hexion Canada”). The Bakelite Acquisition was financed through a combination of available cash and borrowings under a bridge loan facility, which was refinanced with the proceeds of our second-priority senior secured floating rate notes issued on May 20, 2005 (the “New Floating Rate Notes”) and borrowings under our senior secured credit facilities (collectively the “Bakelite Financing”). The Bakelite Acquisition, the repayment or assumption of certain of Bakelite’s debt in connection therewith and the Bakelite Financing are collectively referred to in this prospectus as the “Bakelite Transaction.”

 

Matters Impacting Comparability of Results

 

Basis of Presentation. The audited Consolidated Financial Statements include the accounts of the Company and its majority-owned subsidiaries, in which minority shareholders hold no substantive participating rights, after elimination of intercompany accounts and transactions. The Company’s share of the net earnings of 20% to 50%

 

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owned companies, which it has the ability to exercise significant influence over operating and financial policies (but do not control), are included in income on an equity basis. Investments in the other companies are carried at cost.

 

Resolution Performance, Borden Chemical and Resolution Specialty were considered entities under the common control of Apollo as defined in EITF 02-5 “Definition of Common Control in Relation to FASB Statement of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations.” As a result of the Combinations, the financial statements of these entities are presented retroactively on a consolidated basis in a manner similar to a pooling of interests, and include the results of operations of each business only from the date of acquisition by Apollo.

 

The financial data for Hexion for the year ended December 31, 2003 include the results of operations of Resolution Performance only.

 

The financial data for Hexion for the year ended December 31, 2004, includes:

 

    The results of operations of Resolution Performance for the full year ended December 31, 2004,

 

    The results of operations of Resolution Specialty since the date of the acquisition of Resolution Specialty by Apollo on August 2, 2004, and

 

    The results of operations of Borden Chemical since the acquisition of Borden Chemical by Apollo on August 12, 2004.

 

The financial data for Hexion for the year ended December 31, 2005 includes:

 

    The results of operations of Resolution Performance for the full year ended December 31, 2005,

 

    The results of operations of Borden Chemical for the full year ended December 31, 2005,

 

    The results of operations of Resolution Specialty for the full year ended December 31, 2005 and

 

    The results of operations of Bakelite since the completion of the Bakelite Acquisition on April 29, 2005.

 

Accordingly, the results of operations of Hexion for periods prior to the Borden Chemical and Resolution Specialty acquisitions and the Bakelite Acquisition are not comparable to results for subsequent periods. In order to enhance comparability, management’s discussion and analysis of financial condition and results of operations includes additional supplemental data regarding our reportable segments for the years ended December 31, 2005 and 2004.

 

2006 Completed Acquisitions

 

On January 31, 2006, we completed the purchase of the decorative coatings and adhesives business unit of The Rhodia Group. The Rhodia business had 2004 sales of approximately $180, with 8 manufacturing facilities in Europe, Australia and Thailand. The acquisition was funded through a combination of available cash and existing credit lines.

 

On March 1, 2006, we acquired the global wax compounds business of Rohm and Haas. The purchase included Rohm and Haas’ wax compounds technology and product lines, manufacturing equipment and other business assets. The acquisition was funded through available cash.

 

Outlook

 

We have experienced an improvement in demand in the markets we serve and expect to see continued improvement in demand in 2006. Supply/demand fundamentals are expected to improve, both in industrialized and developing nations. We expect this trend to result in higher utilization rates for the thermosetting resins industry, which in turn will lead to continued price increases. Furthermore, we feel that the formation of Hexion will continue to lead to improved technical capabilities for the combined entities and an ability to service our customers better.

 

However, raw material volatility could continue through 2006 because of, among other things, political instability in the Middle East or supply disruptions elsewhere, including as a result of hurricanes and other natural disasters, such as Hurricanes Katrina and Rita. There can be no assurances that (i) any global recovery will continue during 2006, (ii) we will be able to realize margins we have historically achieved as feedstock costs decline or (iii) our feedstock costs will not rise faster than our product prices and, therefore, reduce our margins.

 

We believe we will be able to mitigate such volatility due to a number of factors: (i) our actions taken in 2005 to implement monthly or quarterly pricing mechanisms in many product lines will improve our ability to

 

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react to changing market conditions in 2006; (ii) the value-added nature of many of our product lines will allow us to continue to pass through additional feedstock price increases; and (iii) the roll-off of several long-term raw material contracts should have a step-change effect in lowering our feedstock costs.

 

There can be no assurances that (i) demand for our products will increase during 2006 or (ii) past or future price increases by us or our competitors will be accepted by our customers or that we will not lose any significant customers or volumes in the future as a result of these price increases.

 

We expect to generate increasing free cash flow (cash flow from operating activities less anticipated capital expenditures) in the future due to improving operating characteristics and the absence of one-time costs associated with the Hexion formation. Our products are generally less capital intensive to manufacture than many other products in the chemical industry and, as a result, we have relatively low maintenance capital and moderate working capital requirements. Furthermore, due to our income tax assets and other structuring considerations, we expect to have very low cash tax requirements for the foreseeable future. Additionally, management is currently targeting $250 million in synergies from the Hexion Formation, of which $125 million of net cost savings have been specifically identified, which should further improve free cash flow. Our plan indicates that our $250 million synergy target will consist of approximately 40% in purchasing savings, 20% in manufacturing efficiencies, 15% in selling, general and administrative expense savings and 25% in new product development and global product line management. Management has developed detailed implementation plans to achieve the $125 million of cost savings. We achieved cost savings of $20 million in 2005. We expect that approximately 60% of the $125 million near term cost savings will be achieved by the end of 2006 with the remainder expected to be achieved in the following year. We expect to incur one-time costs of $75 million in connection with implementing these synergies. We expect that all of these factors will enable us to generate increased free cash flow, which we anticipate will be available to reduce indebtedness or for other strategic purposes.

 

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Overview of Results

 

Our net sales increased to $4,470 in 2005 from $2,019 in 2004, an increase of $2,451. In 2005, the Borden Transaction, the Resolution Specialty Transaction and the Bakelite Acquisition (“the 2005 acquisitions”) added $2,195 in incremental net sales. Excluding the incremental impact of the 2005 acquisitions, our net sales increased $256 in 2005, or approximately 13%. This increase was primarily due to increased average selling prices, as a result of pricing improvement and the pass through of raw material price increases, and favorable product mix.

 

Our gross profit increased $428 in 2005 from $234 in 2004 to $662. The 2005 acquisitions added $309 in incremental gross profit in 2005. Excluding the impact of these acquisitions, our gross profit increased $119 in 2005, or approximately 51%, as the impact of increased average selling prices and favorable product mix more than offset the increase in raw material prices and the higher cost of natural gas.

 

Our operating income increased $199 in 2005 from $9 in 2004 to $208. This improvement was primarily driven by the improvement in gross profit discussed above. Also contributing to the improvement was a $12 reduction in transaction related costs. Offsetting these improvements was an increase in selling, general and administrative expense (SG&A) of $237. The 2005 acquisitions accounted for $188 of this increase in SG&A. We also recognized stock-based compensation expense of $12 in 2005.

 

Our net loss improved by $18 to a loss of $87 in 2005 from a loss of $105 in 2004. This improvement was primarily due to the improvement in operating income discussed above. Partially offsetting the increase in operating income was increased interest expense of $87 due to high average debt levels and higher interest rates, a $17 write-off of deferred financing fees and an increase in non-operating expense primarily due to foreign exchange losses. We also incurred income tax expense of $48 in 2005. Additionally, we incurred a $9 loss related to discontinued operations.

 

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Results of Operations by Segment

 

Following is a comparison of Net sales and Segment EBITDA. Segment EBITDA is defined as EBITDA adjusted to exclude certain non-cash and non-recurring expenses. Segment EBITDA is the primary performance measure used by the Company in the evaluation of its operating results and in determining allocations of capital resources among our segments. Segment EBITDA is also the profitability measure used to set management and executive incentive compensation. Corporate and Other primarily represents certain corporate general and administrative expenses that are not allocated to the segments.

 

     Year Ended December 31,

     2005

    2004

    2003

Net Sales to Unaffiliated Customers (1)(2):

                      

Epoxy and Phenolic Resins

   $ 1,909     $ 1,096     $ 782

Formaldehyde and Forest Products Resins

     1,281       458      

Coatings and Inks

     886       325      

Performance Products

     394       140      
    


 


 

     $ 4,470     $ 2,019     $ 782
    


 


 

Segment EBITDA (2):

                      

Epoxy and Phenolic Resins

   $ 245     $ 93     $ 61

Formaldehyde and Forest Products Resins

     152       51      

Coatings and Inks

     63       26      

Performance Products

     52       16      

Corporate and Other

     (43 )     (10 )    

(1) Intersegment sales are not significant and, as such, are eliminated within the selling segment
(2) Net sales and Segment EBITDA in 2005 includes Bakelite results from the date of acquisition, April 29, 2005. Net sales and Segment EBITDA in 2004 includes Resolution Specialty results from August 2, 2004 and Borden Chemical results from August 12, 2004, their respective dates of acquisition by Apollo.

 

2005 vs. 2004 Segment Results

 

Epoxy and Phenolic Resins

 

Epoxy and Phenolic Resins’ net sales increased by $813 to $1,909 compared to 2004. The Bakelite Acquisition and the Borden Transaction contributed $629 of incremental net sales in 2005. Excluding the incremental impact of the acquisitions, net sales increased $184, or 17%, as a result of increased average selling

 

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prices and favorable product mix, partially offset by decreased volume. Overall average selling prices increased from prior year due to an increased emphasis on pricing. Overall volumes decreased from the prior year due to an increased emphasis on pricing improvement versus volume growth. Epoxy and Phenolic Resins’ Segment EBITDA increased by $152 to $245 compared to 2004. The Bakelite Acquisition and the Borden Transaction contributed $59 of incremental Segment EBITDA in 2005. Excluding the incremental impact of these acquisitions, Segment EBITDA increased $93, or 100%, as a result of increased average selling prices and favorable product mix, as discussed above. Hurricanes Katrina and Rita negatively impacted results by approximately $13 due to incremental costs associated with shutting down and restarting plants and higher utility and raw material costs.

 

Formaldehyde and Forest Products Resins

 

Formaldehyde and Forest Products Resins’ net sales increased by $823 to $1,281 compared to 2004. The Borden Transaction and the Bakelite Acquisition contributed $802 of incremental net sales in 2005. Excluding the incremental impact of these acquisitions, net sales increased $21, or 5%. This increase in net sales is a result of strong pricing for our resins and formaldehyde products due to the pass through of raw material price increases. Favorable currency translation of approximately $7, as both the Canadian dollar and the Brazilian Real strengthened versus the U.S. dollar, also contributed to the net sales increase. Partially offsetting these favorable items was a decrease in volumes primarily in our formaldehyde products caused by hurricane related customer outages. Formaldehyde and Forest Products Resins’ Segment EBITDA increased by $101 to $152 compared to 2004. The Borden Transaction and the Bakelite Acquisition contributed $97 of incremental Segment EBITDA in 2005. Excluding the impact of these acquisitions, Segment EBITDA increased $4, or 8%, as a result of strong pricing for our resins and formaldehyde products due to the pass through of raw material price increases. In 2004, we experienced unfavorable lead/lag as raw material prices increased, and we were not been able to pass these price increases through to our customers. The positive pricing impact more than offset the impact of lower formaldehyde volumes as discussed above. Hurricanes Katrina and Rita negatively impacted Segment EBITDA by approximately $10 in 2005 due to lost sales and incremental costs associated with shutting down and restarting plants and higher utility and raw material costs.

 

Coatings and Inks

 

Coatings and Inks’ net sales increased by $561 to $886 compared to 2004. The Resolution Specialty Transaction contributed $525 of incremental sales in 2005. Excluding the impact of the Resolution Specialty Transaction, net sales increased $36, or 11%. This increase in net sales is a result of strong pricing across all our products, as well as favorable product mix. Coatings and Inks’ Segment EBITDA increased by $37 to $63 compared to 2004. The Resolution Specialty Transaction contributed $42 of incremental Segment EBITDA in 2005. Excluding the impact of the Resolution Specialty Transaction, Segment EBITDA decreased $5, or 19%. Hurricanes Katrina and Rita negatively impacted 2005 Segment EBITDA by approximately $3 due to incremental costs associated with higher utility and raw material costs.

 

Performance Products

 

Performance Products’ net sales increased by $254 to $394 compared to 2004. The Borden Transaction contributed $239 of incremental sales in 2005. Excluding the impact of the Borden Transaction, net sales increased $15, or 11%. This increase in net sales is a result of increased volumes in our foundry products, improved pricing in Asia Pacific and favorable product mix in our oil field products. Improved foundry volumes were driven by higher non-automotive demand. The increased pricing in Asia Pacific is due to the pass through of raw material price increases. Performance Product’s Segment EBITDA increased by $36 to $52 compared to 2004. The Borden Transaction contributed $28 of incremental Segment EBITDA in 2005. Excluding the impact of the Borden Transaction, Segment EBITDA increased $8, or 50% due to factors discussed above as well as lower processing costs in Asia Pacific. Hurricanes Katrina and Rita negatively impacted Segment EBITDA by approximately $1.

 

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Corporate and Other

 

Corporate and Other expenses increased by $33 to $43 compared to 2004 as a result of the Borden Transaction and the Combinations. Prior to the Combinations, Resolution Performance and Resolution Specialty included their corporate and other expenses in their prior reportable segments’ profitability measure used in the evaluation of their operating results and in determining allocations of capital resources. Upon consummation of the Combinations, we began to consolidate the corporate functions of the four former legacy businesses, and certain corporate general and administrative expenses are not allocated to our segments.

 

2004 vs. 2003 Segment Results

 

Epoxy and Phenolic Resins

 

Epoxy and Phenolic Resins’ net sales increased by $314 to $1,096 compared to 2003. The Borden Transaction contributed $100 of incremental net sales in 2004. Excluding the impact of the Borden Transaction, net sales increased $214, or 27%. The increase in net sales (net of the impact of the Borden Transaction) was a result of higher average prices ($157) and increased volumes ($57). The increase in average prices was primarily attributable to price increases on certain products and the impact of a weaker dollar on our Euro-denominated sales. Segment EBITDA increased by $32 to $93 for the year ended December 31, 2004. The Borden Transaction contributed $10 of incremental Segment EBITDA. Excluding the impact of the Borden Transaction, Segment EBITDA improved $22. The increase was primarily due to higher selling prices across all major product lines. Also contributing to the increase was higher overall volumes in 2004. Partially offsetting these improvements were increased cost of feedstocks due to the increasing price of crude oil and related petrochemical products.

 

Formaldehyde and Forest Products Resins

 

Formaldehyde and Forest Products Resins’ 2004 net sales and Segment EBITDA are a result of the Borden Transaction.

 

Coatings and Inks

 

Coatings and Inks’ 2004 net sales and Segment EBITDA are a result of the Resolution Specialty Transaction.

 

Performance Products

 

Performance Products’ 2004 net sales and Segment EBITDA for Performance Products are a result of the Borden Transaction.

 

Corporate and Other

 

Corporate and Other expenses in 2004 are a result of the Borden Transaction. Resolution Performance, in the past, included their corporate and other expenses in their prior reportable segments’ profitability measure used in the evaluation of their operating results and in determining allocations of capital resources. Upon consummation of the Combinations, we began to consolidate the corporate functions of the four former legacy businesses and certain corporate general and administrative expenses are not allocated to our segments.

 

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Reconciliation of Segment EBITDA to Net Loss:

 

     Year Ended December 31,

 
     2005

    2004

    2003

 

Segment EBITDA:

                        

Epoxy and Phenolic Resins

   $ 245     $ 93     $ 61  

Formaldehyde and Forest Products Resins

     152       51        

Coatings and Inks

     63       26        

Performance Products

     52       16        

Corporate and Other

     (43 )     (10 )      

Reconciliation:

                        

Items not included in Segment EBITDA

                        

Transaction costs

     (44 )     (56 )      

Non-cash charges

     (30 )     (2 )     (13 )

Unusual items:

                        

Purchase accounting effects/inventory step-up

     (16 )     (10 )      

Discontinued operations

     (9 )            

Business realignments

     (9 )     (3 )      

Other

     (31 )     (7 )      
    


 


 


Total unusual items

     (65 )     (20 )      
    


 


 


Total adjustments

     (139 )     (78 )     (13 )

Interest expense, net

     (204 )     (117 )     (77 )

Write-off of deferred financing fees

     (17 )            

Income tax benefit (expense)

     (48 )           37  

Depreciation and amortization

     (148 )     (86 )     (58 )
    


 


 


Net loss

   $ (87 )   $ (105 )   $ (50 )
    


 


 


 

Items not included in Segment EBITDA

 

Transaction costs include merger costs related to the Bakelite Acquisition and the Combinations and expenses associated with terminated acquisition activities. Non-cash charges represent impairments of fixed assets and goodwill, stock based compensation and unrealized foreign currency exchange losses on debt instruments denominated in currencies other than the functional currency of the holder. The 2005 purchase accounting effects/inventory step-up adjustment relates to the fair value step-up of Resolution Performance’s inventory carrying value as a result of the Combinations and the fair value step-up of Bakelite’s inventory carrying value as a result of the Bakelite Acquisition. The 2004 purchase accounting effects/inventory step-up adjustment relates to the fair value step-up of Resolution Specialty’s inventory carrying value as a result of the Resolution Specialty Transaction. The results of discontinued operations are not included in our Segment EBITDA measure (see Note 4 to the audited Consolidated Financial Statements). The business realignment adjustment represents plant closure costs, including plant employee severance, and environmental remediation costs associated with closing plants, as well as other employee severance. Other unusual items not included in Segment EBITDA represent expenses deemed by management to be non-recurring in nature. In 2005, these items principally consisted of certain non-recurring litigation expenses, a foreign currency loss on an exchange rate hedge related to the Bakelite Acquisition, integration costs and incremental non-recurring advisor and external audit fees related to the Bakelite Acquisition and the Combinations. In 2004, other unusual items included incremental expenses incurred as a result of a mechanical failure at a Brazilian formaldehyde plant and costs related to the integration of the Resolution Specialty Transaction.

 

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Non-Operating Expenses and Income Tax Expense

 

Non-operating expense

 

     Year Ended December 31,

     2005

   2004

   2003

Interest expense, net

   $ 204    $ 117    $ 77

Write-off of deferred financing fees

     17      —        —  

Other non-operating expense, net

     16      5      —  
    

  

  

     $ 237    $ 122    $ 77
    

  

  

 

Our total non-operating expenses, net, increased $115 in 2005 as compared to 2004. Net interest expense increased $87 over 2004 due to higher interest rates and higher average debt levels resulting from the Borden Transaction, the Resolution Specialty Transaction, the Bakelite Acquisition and the Hexion Financing. In the second quarter of 2005, we wrote-off deferred financing fees of $17. Of this amount, $6 was related to the Bakelite Acquisition bridge financing arrangement and $11 related to the early termination of the Resolution Performance, Resolution Specialty and Borden Chemical credit facilities. Included in other non-operating expense in 2005 was $9 of foreign exchange losses on the settlement of a contingent forward contract held by us relating to the Bakelite Acquisition and an unrealized loss of $10 related to a U.S. dollar denominated $290 term loan on a Dutch subsidiary’s books.

 

Our total non-operating expenses increased $45 in 2004 as compared to 2003. Interest expense increased $40 over 2003 due to higher average debt balances and interest rates resulting from our issuance of the Original Floating Rate Notes and the Fixed Rate Notes in August 2004 as part of the Borden Transaction and Resolution Specialty Transaction (see “—Liquidity and Capital Resources”), the April 2003 issuance of $200 of 9 1/2% Senior Second Secured Notes due 2010 and the refinancing of the credit agreement in the second and fourth quarters of 2003.

 

Income tax expense (benefit)

 

     Year Ended December
31,


 
     2005

    2004 

   2003

 

Income tax expense (benefit)

   $ 48    $    $ (37 )

Effective tax rate

                

 

Despite a loss from continuing operations before income tax of $29 the Company recognized $48 of income tax expense in 2005. The federal income tax benefit on the Company’s domestic loss (computed at the federal statutory tax rate) and the release of foreign valuation allowances were more than offset by (i) an increase in the domestic valuation allowance, (ii) foreign income tax on a foreign currency exchange gain on the settlement of an intercompany loan, (iii) increases in accruals related to state and foreign tax contingencies, and (iv) nondeductible expenses, primarily related to the Combinations.

 

Income tax expense in 2004 reflects a federal income tax benefit computed at the federal statutory rate, offset by a provision for taxes associated with the unrepatriated earnings of foreign subsidiaries. This provision was based on management’s decision that foreign earnings could no longer be considered permanently invested after the Borden Transaction. This additional provision allowed the Company to release previously provided valuation allowances against its deferred tax assets. The provision also reflects a write-off of net operating losses, offset by a benefit relating to a change in a foreign enacted tax rate.

 

The 2003 consolidated tax expense reflects a federal income tax benefit computed at the federal statutory rate.

 

Tax Legislation. In 2004, the American Jobs Creation Act of 2004 was signed into law. This Act effectively phases out benefits from the utilization of foreign sales corporations, reduces the number of foreign tax credit

 

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limitation categories, creates a temporary incentive for U.S. companies to repatriate foreign earnings at a significantly reduced effective U.S. tax rate and domestically provides a number of revenue enhancing and reducing provisions in the taxation of corporations. Our management does not anticipate a material impact on the Company as a result of this legislation.

 

Supplemental Data

 

The supplemental segment information presented and discussed below includes the combination of predecessor and successor financial statements for the individual entities that were the predecessors to the combined company, Hexion, and provides what management believes is a meaningful way of analyzing the results of the combined companies on a comparable period basis.

 

     Year ended December 31, 2005

 
     Epoxy and
Phenolic
Resins


   Formaldehyde
and Forest
Products
Resins


   Coatings
and Inks


   Performance
Products


   Corporate
and Other


 

Pro forma Net sales

   $ 2,139    $ 1,298    $ 886    $ 394    $ —    

Pro forma Segment EBITDA

     253      156      63      52      (43 )
     Year ended December 31, 2004

 

Pro forma Net sales

   $ 1,857    $ 1,141    $ 765    $ 342    $ —    

Pro forma Segment EBITDA

     152      143      60      38      (29 )

 

Epoxy and Phenolic Resins

 

Pro forma net sales increased $282, or 15%, to $2,139 in 2005 as compared to the prior year. This increase in Pro forma Net sales is a result of increased average prices, partially offset by decreased volume. Average prices increased while volumes decreased due to an increased emphasis by management on pricing versus volume. Pro forma Segment EBITDA increased $101, or 66%, to $253 in 2005 compared to 2004. This Pro forma Segment EBITDA improvement was driven by the increase in average selling prices discussed above that more than offset higher prices for raw material feedstocks due to the increasing prices of crude oil and related petrochemical products and natural gas. Hurricanes Katrina and Rita negatively impacted 2005 results by approximately $13 due to incremental costs associated with shutting down and restarting plants and higher utility and raw material costs.

 

Formaldehyde and Forest Products Resins

 

Pro forma net sales increased $157, or 14%, to $1,298 in 2005 as compared to 2004 driven by increased pricing and favorable currency translation, partially offset by lower volumes. The increase in pricing was due to the pass through of higher raw material costs to our customers. The favorable currency translation was due to the strengthening of the Canadian dollar and the Brazilian Real versus the U.S. dollar. The decline in volumes was primarily in our formaldehyde products caused by hurricane related customer outages. Pro forma Segment EBITDA increased $13, or 9%, to $156 in 2005 compared to 2004. The Pro forma Segment EBITDA improvement was driven by the factors discussed above. Hurricanes Katrina and Rita negatively impacted the Pro forma Segment EBITDA by approximately $10 in 2005 due to incremental costs associated with shutting down and restarting plants and higher utility and raw material costs.

 

Coatings and Inks

 

Pro forma net sales increased $121 in 2005 to $886 from 2004, a 16% increase. This increase was primarily due to higher average selling prices across all of our products as well as favorable product mix. Pro forma Segment EBITDA increased $3 in 2005 from 2004. The improvement was driven by the positive factors discussed above partially offset by approximately $3 of incremental costs associated with higher utility and raw material costs as a result of Hurricanes Katrina and Rita.

 

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Performance Products

 

Pro forma net sales increased $52 in 2005 compared to 2004, an increase of 15% as a result of improved volumes, higher average selling prices and favorable product mix. Our foundry products volumes increased driven by higher non-automotive demand. Higher average selling prices, primarily in Asia Pacific, was due to the pass through of raw material price increases. Our sales were positively impacted by favorable product mix in our oil field products. Pro forma Segment EBITDA increased $14 in 2005, an increase of 37% compared to 2004. The increase in Pro forma Segment EBITDA was primarily a result of the positive factors discussed above as well as lower processing costs in Asia Pacific. Hurricanes Katrina and Rita negatively impacted Pro forma Segment EBITDA by approximately $1.

 

Cash Flows

 

Cash provided by (used in):

                          
     Year Ended
December 31,


 
     2005

     2004

     2003

 

Operating activities

   $ 171      $ (32 )    $ (43 )

Investing activities

     (354 )      (20 )      7  

Financing activities

     219        148        80  

Effect of exchange rates on cash flow

     (5 )      7        1  
    


  


  


Net change in cash and equivalents

   $ 31      $ 103      $ 45  
    


  


  


 

Operating Activities

 

In 2005, our operating activities generated cash of $171. Net loss, when adjusted for non-cash items, totaled $120 and net trading capital generated cash of $37, due to improved accounts receivable management. We made net cash tax payments of $8 in 2005.

 

In 2004, we used net cash for operating activities of $32. Costs associated with the Borden Transaction of $46 more than offset improvements in other operating income. Increases in other assets, which were partially offset by increases in other liabilities, used net cash of $12. Working capital remained flat as increases in accounts receivables and inventories were offset by increases in accounts payable.

 

Our 2003 operating activities used cash of $43. This includes cash used by operations of $24 and by net trading capital (accounts receivable, inventory and accounts payable) of $27. Our negative cash flow in net trading capital resulted from increasing raw material costs in 2003.

 

Investing Activities

 

Our investing activities used cash of $354 in 2005. We used $252 for the acquisitions of the Bakelite and Pacific Epoxy businesses and $105 for capital expenditures, primarily for plant expansions and improvements.

 

Our 2004 net investing activities used cash of $20. We used cash of $57 for capital expenditures primarily for plant expansions, SAP implementation at Resolution Specialty and other improvements. We paid $152 relating to Resolution Specialty acquisition activity, net of cash acquired, and received $185 relating to cash held by Borden Chemical at the time it became a member of the combined group.

 

Our 2003 net investing activities provided cash of $7. We spent $18 for capital expenditures, primarily for plant expansions and improvements. We realized proceeds of $23 on the sale of forty percent of the outstanding shares in Japan Epoxy Resins Co., Ltd to Resolution Performance joint venture partner, Mitsubishi Chemical Company.

 

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Financing Activities

 

 

In 2005, our financing activities provided cash of $219. Net cash generated by financing activities was primarily due to long-term debt borrowings of $1,193 consisting of the $150 senior secured notes and the $500 term loan under the Hexion Credit Facility and borrowings under a bridge facility for the Bakelite Acquisition (see “—Liquidity and Capital Resources”). These borrowings were partially offset by net debt repayment of $752 and debt financing fees paid of $22 related to the financings. We paid a dividend of $523, which was funded through net the proceeds received from the issuance of preferred stock of $334 and from amounts borrowed under the Hexion Credit Facility. We also made payments of $11 for costs related to our proposed IPO.

 

Our financing activities in 2004 provided cash of $148. Net cash generated by financing activities was primarily due to the issuance of debt related to the Resolution Specialty Transaction of $121, offset by net debt repayments by Resolution Performance and Borden Chemical of $23. Also, we received a cash inflow of $60 related to the Resolution Specialty Transaction.

 

Our 2003 financing activities provided cash of $80. This amount includes net debt borrowing of $103, offset by the payment of a constructive distribution related to certain pension costs to Shell on behalf of Resolution Performance.

 

Liquidity and Capital Resources

 

Our primary source of liquidity is cash flow generated from operations. We also have availability under our senior secured credit facilities (see below), subject to certain conditions. Our primary liquidity requirements are debt service, working capital requirements, contractual obligations and capital expenditures.

 

We are a highly leveraged company. Our liquidity requirements are significant, primarily due to our debt service requirements. At December 31, 2005, we had $2,354 principal amount of outstanding indebtedness, of which approximately $800 constituted floating rate debt and bank loans and the remainder constituted fixed rate indebtedness. There were no borrowings outstanding under our senior secured revolving credit facility at December 31, 2005. We also had $183 of cash and equivalents on our balance sheet as well as unused borrowing availability under our senior secured revolving credit facility of $221 at December 31, 2005.

 

Effective October 11, 2005, we entered into a $289 cross-currency and interest rate swap agreement structured for a non-U.S. subsidiary’s $290 U.S. dollar denominated term loan. The swap is a three-year agreement designed to offset balance sheet and interest rate exposures and cash flow variability associated with exchange rate fluctuations on the term loan.

 

In connection with the Hexion Formation, we have declared but not yet paid a dividend of $27 to our shareholder, which is expected to be principally paid in the second quarter of 2007 and is classified in Other long-term liabilities.

 

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Senior Credit Facilities

 

In May 2005, we entered into senior secured credit facilities and replaced and repaid various credit facilities and debt. The six year $775 senior secured credit facilities have a $225 revolving credit facility, a $500 term loan facility and a $50 synthetic letter of credit facility (“LOC”). Repayment of 1% total per annum of the term loan and synthetic letter of credit facilities must be made (in the case of the term loan facility, quarterly, and in the case of the synthetic letter of credit facility, annually) with the balance payable upon the final maturity date. Further, we may be required to make additional repayments on the term loan beginning in the second quarter of 2007 if we generate excess cash flow, as defined in the agreement.

 

The interest rates with respect to loans to Hexion under our senior secured credit facilities are based on, at our option, (a) adjusted LIBOR plus 2.50% or (b) the higher of (i) JPMorgan Chase Bank, N.A.’s (JPMCB) prime rate or (ii) the Federal Funds Rate plus 0.5%, in each case plus 1.00%.

 

The interest rates with respect to loans to the Canadian subsidiary borrower under our senior secured credit facilities are based on (a) for loans made in dollars, at our option, (1) adjusted LIBOR plus 2.50% or (2) the higher of (i) JPMCB’s reference rate for U.S. dollar-denominated loans made in Canada and (ii) the Federal Funds Rate plus 0.5%, in each case plus 1.00% or (b) for loans made in Canadian Dollars, at our option, (1) a Canadian Bankers’ Acceptances rate (depending on the lender, either the average bankers’ acceptance rate quoted on the Reuters CDOR page or the lesser of such average plus 0.10% and the average bankers’ acceptance rate quoted to JPMCB by certain reference banks) plus 2.50% or (2) the higher of (i) JPMCB’s Toronto Branch’s prime rate and (ii) the average bankers’ acceptance rate quoted on the Reuters CDOR page plus  1/2 of 1%, in each case plus 1.00%.

 

The interest rates with respect to loans to the U.K. subsidiary borrowers under our senior secured credit facilities are based on (a) for loans made in dollars, at our option, adjusted LIBOR plus 2.50% or the rate quoted by JPMCB as its base rate for such loans plus 1.00%, (b) for loans made in Sterling, at our option, adjusted LIBOR plus 2.50% or the rate quoted by JPMCB as its base rate for such loans plus 1.00% or (c) for loans made in euros, at our option, EURO LIBOR plus 2.50% or the rate quoted by JPMCB as its base rate for such loans plus 1.00%.

 

The interest rates with respect to loans to the Dutch and German subsidiary borrowers under our senior secured credit facilities are based on, at our option, EURO LIBOR plus 2.50% or the rate quoted by JPMCB as its base rate for such loans, plus 1.00%.

 

Our senior secured credit facilities are secured by substantially all the assets of (i) prior to the initial public offering of our common stock, Hexion LLC, which will consist of a perfected first-priority pledge of all our capital stock and (ii) at all times, us and the subsidiary guarantors, including but not limited to: (a) a first- priority pledge, subject to certain exceptions, of all capital stock held by us or any subsidiary guarantor (which pledge, with respect to obligations in respect of the U.S. borrowings secured by a pledge of the stock of any first-tier foreign subsidiary, shall be limited to 100% of the non-voting stock (if any) and 65% of the voting stock of such foreign subsidiary) and (b) perfected first-priority security interests in, and mortgages in, substantially all tangible and intangible assets of us and each subsidiary guarantor.

 

Notwithstanding the foregoing, (i) assets of foreign subsidiary guarantors only secure obligations in respect of the foreign borrowings, (ii) the collateral does not include (A) any real estate, fixtures or equipment of us or any of our subsidiaries located within the United States (except for assets that our board of directors determines do not constitute principal property under the indentures for our debentures due 2016, 2021 and 2023) and (B) any evidence of indebtedness for borrowed money of certain subsidiaries held by us or our subsidiaries and (iii) the collateral is subject to certain other exceptions.

 

The credit agreement contains, among other provisions, restrictive covenants regarding indebtedness, payments and distributions, mergers and acquisitions, asset sales, affiliate transactions, capital expenditures and the

 

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maintenance of certain financial ratios. Payment of borrowings under our senior secured credit facilities may be accelerated if there is an event of default. Events of default include the failure to pay principal and interest when due, a material breach of representation or warranty, covenant defaults, events of bankruptcy and a change of control.

 

At December 31, 2005, we had no outstanding borrowings under the revolving credit facility and $54 outstanding LOCs and had additional borrowing capacity of $221.

 

At December 31, 2005, we were in compliance with the covenants and restrictions in all credit facilities.

 

In the second quarter of 2005, we wrote off deferred financing costs of $17. Of this amount, $6 was related to the Bakelite Acquisition bridge financing arrangement, and $11 related to the early termination of the Resolution Performance, Resolution Specialty and Borden Chemical credit facilities. This expense is included in Write-off of deferred financing fees on the audited Consolidated Statements of Operations.

 

Our Australian subsidiary entered into a five-year secured credit facility in the fourth quarter of 2003 (the “Australian Facility”), which provides for a maximum borrowing of AUD$15, or approximately $11. At December 31, 2005, outstanding debt under this facility was $6, of which $5 is classified as long-term. In addition, there was approximately $3 of short-term debt under the facility. The Australian Facility is secured by liens against substantially all of the assets of the Australian business including the stock of the Australian subsidiaries. At December 31, 2005, the net book value of the collateral securing the Australian Facility was approximately $34. In addition, we pledged the stock of the Australian subsidiaries as collateral for borrowing under the Australian Facility. This facility includes a fixed rate facility used for the acquisition, as well as a revolver. At December 31, 2005, $6 was outstanding under the fixed rate facility at an interest rate of 6.4%. The Australian Facility contains restrictions relative to the Australian businesses on dividends, the sale of assets and additional borrowings. The Australian Facility also contains financial covenants applying to the Australian subsidiaries including current ratio, interest coverage, debt service coverage and leverage. The fixed portion of the Australian Facility requires minimum quarterly principal reductions totaling AUD$0.5 (approximately $0.4). The Australian Facility requires semi-annual principal reductions based on a portion of excess cash as defined in the agreement. At December 31, 2005, the maximum borrowing allowable under the Australian Facility was AUD$15 (approximately $11), of which about AUD$3 (approximately $2), after outstanding LOCs and other draws, was unused and available.

 

Additional international credit facilities provide availability totaling approximately $115 as of December 31, 2005. Of this amount, approximately $51 was available to fund working capital needs and capital expenditures at December 31, 2005. These credit facilities have various expiration dates ranging from 2006 through 2008. While these facilities are primarily unsecured, portions of the lines are secured by equipment. At December 31, 2005, the net book value of collateral securing a portion of these facilities was approximately $10. We guarantee up to $7 of the debt of one of our Brazilian subsidiaries, included in these facilities.

 

HAI entered into a three-year asset based revolving credit facility in 2004, which provides for a maximum borrowing of $15 (the “HAI Facility”). Maximum borrowing allowable under the HAI Facility is based upon specific percentages of eligible accounts receivable and inventory and is secured with inventory, accounts receivable and property and equipment of HAI. At December 31, 2005, the net book value of collateral securing the HAI Facility was approximately $38. The HAI Facility provides up to $2 for LOCs. The HAI Facility contains restrictions relative to HAI on dividends, affiliate transactions, minimum availability ($2 in 2005), additional debt and capital expenditures ($2 in 2005). In addition, HAI is required to maintain a minimum trailing twelve-month debt coverage ratio of 1.5 to 1.0 and a monthly debt to tangible capital ratio of less than 2.5 to 1.0. At December 31, 2005, borrowings allowable under the HAI Facility was $13 of which $11 was unused and available, after the minimal availability requirement.

 

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Senior Secured Notes

 

In 2003, Resolution Performance and RPP Capital Corporation issued $140 aggregate principal amount of 8% Senior Secured Notes due 2009 in a private offering. Hexion assumed the obligations of Resolution Performance under the 8% Senior Secured Notes in connection with the consummation of the Combinations. The $140 of 8% Senior Secured Notes are senior secured obligations ranking equal in right of payment to all of our existing and future senior debt and senior in right of payment with all existing and future subordinated indebtedness. The 8% Senior Secured Notes are secured by a second-priority lien subject to permitted liens, on all of the domestic assets (subject to certain exceptions) that secure obligations under our senior secured credit facilities and a portion of the capital stock of direct and indirect domestic subsidiaries and direct foreign subsidiaries. Interest is payable semi-annually in cash on December 15 and June 15, beginning June 15, 2004. The 8% Senior Secured Notes mature on December 15, 2009 and may be redeemed in whole at any time or in part from time to time, on and after December 15, 2006, at the specified redemption prices set forth under the related indenture.

 

In 2003, Resolution Performance and RPP Capital Corporation issued $200 aggregate principal amount of 9 1/2% Senior Second Secured Notes due 2010 in private offerings. Hexion assumed the obligations of Resolution Performance under the 9 1/2% Senior Second Secured Notes in connection with the consummation of the Combinations. The 9 ½% Senior Second Secured Notes were subsequently exchanged for registered notes in a registered exchange offer. The $200 of 9 1/2% Senior Second Secured Notes are senior secured obligations ranking equal in right of payment to all of Hexion’s existing and future senior debt and senior in right of payment with all existing and future subordinated indebtedness. The 9 1/2% Senior Second Secured Notes are secured by a second-priority lien, subject to permitted liens, on all of our domestic assets (subject to certain exceptions) that secure obligations under our senior secured credit facilities and a portion of the capital stock of direct and indirect domestic subsidiaries and direct foreign subsidiaries. Interest is payable semi-annually in cash on April 15 and October 15, beginning October 15, 2003. The 9 1/2% Senior Second Secured Notes mature on April 15, 2010 and may be redeemed in whole at any time or in part from time to time, on and after April 15, 2006, at the specified redemption prices set forth under the related indenture.

 

In conjunction with the Borden Transaction, Borden Chemical formed two wholly owned finance subsidiaries that borrowed a total of $475 through a private debt offering. Of the debt, $325 is second-priority senior secured notes due 2014 (the “Fixed Rate Notes”), which bear an interest rate of 9%. The remaining $150 of debt is second-priority senior secured floating rate notes due 2010 (the “Original Floating Rate Notes”).

 

The Original Floating Rate Notes and Fixed Rate Notes and guarantees rank equally with all of Hexion’s and the guarantor’s existing and future senior indebtedness, including debt under Borden Chemical’s senior secured credit facilities and the guarantees thereof. The Original Floating Rate Notes and Fixed Rate Notes remain obligations of Hexion after consummation of the Combinations. The Original Floating Rate Notes and Fixed Rate Notes are effectively subordinated to such senior secured credit facilities, our 8% Senior Secured Notes and any other future obligations secured by a first-priority lien (as defined in the indentures governing such notes) on the collateral to the extent of the value of the collateral securing such obligations. The Original Floating Rate Notes and Fixed Rate Notes will rank senior to all of Hexion’s and its guarantors’ existing and future subordinated indebtedness, except as described in the preceding sentence. The Original Floating Rate Notes and Fixed Rate Notes are also effectively subordinated to the liabilities of the non-guarantor subsidiaries, which includes HAI.

 

Interest on the Original Floating Rate Notes will be paid each January 15, April 15, July 15 and October 15. Interest on the Original Floating Rate Notes accrues at an annual rate, reset quarterly, equal to LIBOR plus 475 basis points. At December 31, 2005, the interest rate on the Original Floating Rate Notes was 9.71%. The notes mature July 15, 2010. These notes may be redeemed at any time on or after July 15, 2006 at the applicable redemption price set forth in the indenture for the notes. In addition, up to 35% of these notes may be redeemed

 

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prior to July 15, 2006 with cash proceeds from certain equity offerings at the applicable redemption price set forth in the indenture for the notes. The Original Floating Rate Notes may also be redeemed upon certain changes in tax laws or upon a change in control. There is no sinking fund for the Original Floating Rate Notes.

 

Interest on the Fixed Rate Notes will be paid each January 15 and July 15. The notes mature July 15, 2014. These notes may be redeemed at any time on or after July 15, 2009 at the applicable redemption price set forth in the indenture for the notes. In addition, up to 35% of these notes may be redeemed prior to July 15, 2007 with cash proceeds from certain equity offerings at the applicable redemption price set forth in the indenture for the notes. Prior to July 15, 2009, the Fixed Rate Notes may be redeemed at a price equal to 100% of the principal amount plus accrued interest plus the “make-whole” premium as defined in the indenture for the notes. The Fixed Rate Notes may also be redeemed upon certain changes in tax laws or upon a change in control. There is no sinking fund for the Fixed Rate Notes.

 

In May 2005, we issued $150 Second-Priority Senior Secured Floating Rate Notes due 2010 (the “New Floating Rate Notes”). The New Floating Rate Notes have substantially the same covenants and events of default as the Original Floating Rate Notes. The New Floating Rate Notes were issued at a price of 98.846%. Interest on the New Floating Rate Notes accrues at a rate per annum, reset quarterly, equal to LIBOR plus 5.50% and is payable on January 15, April 15, July 15 and October 15, commencing on July 15, 2005. These notes may be redeemed at any time on or after July 15, 2006 at the applicable redemption price set forth in the indenture for the notes. In addition, up to 35% of these notes may be redeemed prior to July 15, 2006 with cash proceeds from certain equity offerings at the applicable redemption price set forth in the indenture for the notes. The New Floating Rate Notes are collateralized by a second-priority security interest in the same collateral as the remaining $150 of our Second-Priority Senior Secured Floating Rate Notes, our 9% Second Priority Senior Secured Notes and our 9 1/2% Senior Second Secured Notes which are all second in priority (subject to Permitted Liens) to our senior secured credit facilities.

 

Following the Combinations, the Company, certain of our U.S. subsidiaries and Hexion U.S. Finance Corporation (formerly known as Borden U.S. Finance) have guaranteed the senior secured debt previously issued by Resolution Performance.

 

In December 2005, we filed a registration statement with the SEC to consummate an exchange offer on the Fixed Rate and Floating Rate Notes. Effective February 2006, a premium of 75 basis points was eliminated upon the exchange.

 

Debentures

 

In 2000, $328 aggregate principal amount of 13 1/2% Senior Subordinated Notes due 2010 were issued in private offerings by Resolution Performance and RPP Capital Corporation. Hexion assumed the obligations of Resolution Performance under the 13 1/2% Senior Subordinated Notes in connection with the consummation of the Combinations. These notes were subsequently exchanged for registered notes. The $328 of 13 1/2% Senior Subordinated Notes are senior subordinated unsecured obligations ranking junior in right of payment to all of existing and future senior debt and all liabilities of subsidiaries that do not guarantee the notes. The proceeds from the issuance of $200 of the 13 1/2% Senior Subordinated Notes in November 2000 were used to finance in part the recapitalization and related transaction costs and expenses. Interest on the 13 1/2% Senior Subordinated Notes is payable semi-annually in cash on each May 15 and November 15. The 13 1/2% Senior Subordinated Notes mature on November 15, 2010 and may be redeemed in whole at any time or in part from time to time, on and after November 15, 2005, at the specified redemption prices set forth under the related indenture.

 

In connection with the Resolution Specialty Transaction, Resolution Specialty executed a Senior Subordinated Note Purchase Agreement (“Seller Note Financing”) with Eastman on August 2, 2004, which provided for the sale of $50 aggregate principal amount of Senior Subordinated Notes of Resolution Specialty to Eastman due and payable in 2011. Such notes were delivered to Eastman as partial consideration of the Resolution Specialty Transaction. Interest was payable at a base rate equal to the seven year Treasury plus additional basis points ranging from 350 to 550, payable semi-annually on February 1 and August 1. The Seller Note Financing provided for payments-in-kind, whereby Resolution Specialty was permitted to pay interest in either dollars or Notes until the third anniversary. The Seller Note Financing was

 

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subordinate to the Credit Agreement, and contained restrictive covenants which could trigger acceleration of repayment in the event of default absent a waiver. Such restrictive covenants included, among other provisions, restrictions on payments and distributions, mergers and acquisitions and transactions with affiliates. We repaid the Senior Subordinated Notes of Resolution Specialty on May 31, 2005 in connection with the consummation of the Combinations.

 

The 9 1/5% debentures due in 2021, the 7 7/8% debentures due in 2023 and the 8 3/8% sinking fund debentures due in 2016 were outstanding prior to the Borden Transaction. These debentures are senior obligations of Hexion and rank equally with all of Hexion’s existing and future senior indebtedness. However, because these debentures are unsecured, they are effectively subordinated to Hexion’s senior secured indebtedness, including the senior secured credit facilities, the 8% Senior Secured Notes, the 9 1/2% Senior Second Secured Notes, the Original Floating Rate Notes, the Fixed Rate Notes and the New Floating Rate Notes.

 

Other Borrowings

 

In addition, the Company finances certain insurance premiums. Short-term borrowings under this arrangement include $9 and $6 at December 31, 2005 and 2004 respectively.

 

The $34 Parish of Ascension Industrial Revenue Bonds (IRBs) are related to the purchase, construction and installation of air and water pollution control facilities that are no longer owned by Borden Chemical. The tax-exempt status of the IRBs is based upon their being no change in the use of the facilities, as defined by the Internal Revenue Code. Borden Chemical continues to monitor the use of the facilities by the current owner. If a change in use were to occur, Borden Chemical could be required to take remedial action, including redeeming all of the bonds.

 

On October 6, 2004, we entered into an agreement to acquire Bakelite Aktiengesellschaft (“Bakelite”). We consummated the Bakelite Acquisition on April 29, 2005. As discussed in Note 3 to the audited Consolidated Financial Statements, we financed the acquisition through a combination of debt and cash.

 

Series A Preferred Stock

 

In May 2005, Hexion Escrow Corp., a subsidiary of Hexion which merged into Hexion coincidental with the Combinations, offered 14 million shares of Redeemable Series A Floating Rate Preferred Stock, which we refer to as the Preferred Stock, par value $0.01 per share, and a liquidation preference of $25 per share. The net proceeds from the Series A Preferred Stock were used to pay a dividend to the Company’s parent. The Series A Preferred Stock accumulate cumulative preferential dividends from the issue date at an initial rate of LIBOR plus 8.0%, compounded semi-annually. The dividend rate increases 75 basis points every six months beginning November 15, 2005 until May 15, 2007, at which time the rate is LIBOR plus 11.0%. As of December 31, 2005 the dividend rate was 13.3%. Dividends will be paid by issuing additional shares of Series A Preferred Stock through May 15, 2010. Thereafter, dividends will be required to be paid in cash. After November 15, 2005, the Company has the option to redeem all or a portion of the Series A Preferred Stock at between 101% and 103% of the aggregate liquidation value plus accrued and unpaid dividends. On or after May 15, 2007, the Company may convert the Series A Preferred Stock from a floating rate security to a fixed rate security, with dividends payable at an annual rate equal to 14.0%. On October 14, 2014, or upon a change in control of the Company, the Series A Preferred Stock shareholders have the option to require the Company to repurchase all or a portion of the Series A Preferred Stock. The Company expects to use a portion of the proceeds it receives from its proposed IPO, together with available cash, (See Note 1 to the audited Consolidated Financial Statements) to redeem the Series A Preferred Stock. In the event that the Series A Preferred Stock is not redeemed by November 15, 2006, the initial purchasers of the Series A Preferred Stock are entitled to receive a rollover fee of 1.5% of the aggregate initial liquidation preference of the Series A Preferred Stock held on that date, which will result in a cash payment of up to $5.

 

Capital Expenditures

 

We plan to spend approximately $118 on capital expenditures in 2006. This amount was determined through the budget process and is subject to change in all respects at the discretion of the board. Consideration was given to future product demand projections, existing plant capacity and external customer trends. Of the $118 anticipated future capital expenditures, based on our historical experience we expect approximately $65 will be used for maintenance and environmental projects. We expect the remaining $53 will be used to expand plant capacity as necessary to meet expected demand. We plan to fund capital expenditures through operations and, if necessary, through available lines of credit. We have no material firm commitments relating to these anticipated capital expenditures at December 31, 2005.

 

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Contractual Obligations

 

The following table presents our contractual cash obligations at December 31, 2005. Our actual contractual cash obligations consist of legal commitments at December 31, 2005, requiring us to make fixed or determinable cash payments, regardless of the contractual requirements of the vendor to provide future goods or services. This table does not include information on most of our recurring purchases of materials for use in production, as our raw materials purchase contracts do not meet this definition because they generally do not require fixed or minimum quantities. Contracts with cancellation clauses are not included, unless such cancellation would result in major disruption to our business. For example, we have contracts for information technology support that are cancelable, but this support is essential to the operation of our business and administrative functions; therefore, amounts payable under these contracts are included.

 

     Payments Due By Year

Contractual Obligations


   2006

   2007

   2008

   2009

   2010

   2011 and
beyond


   Total

Long-term debt, including current maturities

   $ 50    $ 14    $ 18    $ 181    $ 842    $ 1,237    $ 2,342

Capital lease obligations

     1      1      —        —        3      7      12

Operating leases

     26      23      19      14      11      13      106

Unconditional purchase obligations (a)

     234      131      107      99      19      110      700

Redeemable preferred stock

     5      —        —        —        48      1,053      1,106

Interest on fixed rate debt (b)

     146      146      145      145      121      503      1,206
    

  

  

  

  

  

  

Total

   $ 462    $ 315    $ 289    $ 439    $ 1,044    $ 2,923    $ 5,472
    

  

  

  

  

  

  


 

(a) Unconditional purchase obligations are comprised of the fixed or minimum amounts of goods and/or services under long-term contracts and assumes that certain contracts are terminated in accordance with their terms after giving the requisite notice which is generally two to three years for most of these contracts; however, under certain circumstances, some of these minimum commitment term periods could be further reduced which would significantly decrease these contractual obligations. This table excludes payments relating to income tax, pension and OPEB benefits and environmental obligations due to the fact that, at this time, we cannot determine either the timing or the amounts of payments for all periods beyond 2005 for certain of these liabilities. See Notes 10, 12, 13 and 16 to the audited Consolidated Financial Statements and the following discussions on our environmental, pension, OPEB and income tax liabilities, respectively, for more information on these obligations.
(b) This table excludes interest expense for debt instruments with variable interest rates including the senior secured credit facilities. For the year ended December 31, 2005, this expense was approximately $45.

 

Our current projections for future annual cash payments to our defined benefit pension plans range from approximately $17 to $37 per year, with a total funding requirement for the five years ended in 2010 of $131. The assumptions used by our actuaries in calculating these projections included an 8.2% weighted average annual return on assets for the years 2006 – 2010 and the continuation of current law and plan provisions. We plan to make cash payments of $37 relating to our defined benefit pension plans in 2006. These amounts include benefit payments to be made under unfunded defined benefit pension plans.

 

Our projected annual future plan benefit payments for our non-pension postretirement plans are approximately $2, with total benefit payments for the five years ended in 2010 of approximately $10 and $8 for the years ended 2011 and beyond.

 

We estimate we will pay current year cash taxes totaling approximately $31 in 2006 for local, state and international liabilities.

 

We expect other environmental expenditures for 2006 – 2010 to total approximately $18.

 

 

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We maintain three stock option plans for our employees: the RPP 2000 Stock Option Plan (which we refer to as the RPP plan), the RSM 2004 Stock Option Plan (which we refer to as the RSM plan) and the BHI Acquisition 2004 Stock Incentive Plan (which we refer to as the 2004 incentive plan). In addition to these option plans, we maintain a stock-based deferred compensation plan. The fair market value of the options granted under the option plans and deferred common stock units granted under the stock-based deferred compensation plan was determined contemporaneously at the date of grant based upon the fair market value of the underlying stock at the date of grant. The options and deferred common stock units granted under the RSM plan and the 2004 incentive plan were granted contemporaneously with the acquisition of Resolution Specialty and Borden Chemical by Apollo in August 2004 and the fair market value of those options and deferred common stock units is equal to the acquisition price paid by Apollo. Substantially all of the options granted under the RPP plan were granted contemporaneously with the acquisition of Resolution Performance by Apollo in November 2000 and the fair market value of those options is equal to the acquisition price paid by Apollo. In 2004, a limited number of options were issued to a new employee under the RPP plan at fair market value as determined by the Board of Directors of Resolution Performance.

 

On May 11, 2005, BHI Acquisition issued options to purchase 84,424 membership units to the Company’s non-management directors. These options have a ten-year life with immediate vesting and exercise upon an IPO. Upon the consummation of an IPO, we will recognize expense of $1, which represents the fair value of the options at the date of grant as determined by the Black-Scholes pricing model.

 

At December 31, 2005, on an as converted basis, there were approximately 4,150,000 options outstanding under all of our employee and director option plans, which include the Resolution Performance 2000 Non-Employee Directors Option Plan and approximately 970,000 deferred common stock units under the deferred compensation plan. All outstanding share awards at December 31, 2005 are denominated in Hexion LLC shares.

 

As a result of modifications associated with the Combinations to the RPP plan, the RSM plan, the 2004 incentive plan and the deferred compensation plan, we recognized a compensation charge of $12 for the year ended December 31, 2005, which is included in selling, general & administrative expense. The total compensation cost to be recognized under such plans was $31 based on an estimated fair value per share of $17.52, the value at the time of the Combinations. We expect to recognize the additional compensation expense of $19 over the vesting period of the underlying stock based awards. These awards are expected to vest over the next seven years.

 

We expect to have adequate liquidity to fund working capital requirements, contractual obligations and capital expenditures over the remainder of the term of our credit facilities with cash received from operations and amounts available under credit facilities.

 

Off-Balance Sheet Arrangements

 

We had no off-balance sheet arrangements as of December 31, 2005.

 

Covenant Compliance

 

Certain covenants contained in the credit agreement governing our senior secured credit facilities and the indentures governing the 8% Senior Secured Notes, 9 1/2% Senior Second Secured Notes and Second-Priority Senior Secured Notes (i) require the maintenance of defined Adjusted EBITDA to Fixed Charges and senior secured debt to Adjusted EBITDA ratios and (ii) restrict our ability to take certain actions such as incurring additional debt or making acquisitions if we are unable to meet these ratios. The most restrictive of these covenants, the covenants to incur additional indebtedness and the ability to make future acquisitions, require an Adjusted EBITDA to Fixed Charges ratio (measured on a trailing four-quarter basis) of 2.25:1. Failure to comply with these covenants can result in limiting our long-term growth prospects by hindering our ability to incur future indebtedness or grow through acquisitions.

 

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Fixed charges are defined as interest expense excluding the amortization or write-off of deferred financing costs. Adjusted EBITDA is defined as EBITDA further adjusted to exclude certain non-cash, non-recurring and realized or expected future cost savings directly related to prior acquisitions and the Combinations. We believe that the inclusion of the supplemental adjustments applied in calculating Adjusted EBITDA is appropriate to provide additional information to investors to demonstrate compliance with our financial covenants and assess our ability to incur additional indebtedness in the future. Adjusted EBITDA and Fixed Charges are not defined terms under GAAP. Adjusted EBITDA should not be considered an alternative to operating income or net income as a measure of operating results or an alternative to cash flows as a measure of liquidity. Fixed Charges should not be considered an alternative to interest expense. Because we are highly leveraged, we believe that the inclusion of supplementary adjustments to EBITDA applied in presenting Adjusted EBITDA are appropriate to provide additional information to investors to demonstrate compliance with our financing covenants. Adjusted EBITDA has not been adjusted to include $27 for the impact of Hurricanes Katrina and Rita. As of December 31, 2005, we were in compliance with all financial covenants contained in the indentures governing the notes and all our credit facilities.

 

    

Year Ended

December 31,

2005


 

Reconciliation of Net Loss to Adjusted EBITDA

        

EBITDA

        

Net loss

   $ (87 )

Income taxes

     48  

Interest expense, net

     204  

Write-off of deferred financing fees

     17  

Depreciation and amortization expense

     148  
    


EBITDA

     330  

Adjustments to EBITDA

        

Acquisitions EBITDA (1)

     29  

Transaction costs (2)

     44  

Non-cash charges (3)

     30  

Unusual items:

        

Purchase accounting effects/inventory step-up

     16  

Discontinued operations

     9  

Business realignments

     9  

Other (4)

     31  
    


Total unusual items

     65  
    


In process Synergies (5)

     105  
    


Adjusted EBITDA (6)

   $ 603  
    


Fixed charges

   $ 209  
    


Ratio of Adjusted EBITDA to Fixed Charges

     2.89  
    



(1) Represents the incremental EBITDA impact for the Bakelite Transaction, the Rhodia Acquisition and the Rohm and Haas Acquisition as if they had taken place at the beginning of the period.

 

(2) Represents merger costs principally related to the Hexion Formation and Bakelite Acquisition and expenses associated with terminated acquisition activities.

 

(3) Includes non-cash charges for impairments of fixed assets, stock based compensation, and unrealized foreign currency exchange loss on debt instruments denominated in currencies other than the functional currency of the holder.

 

(4) Includes certain non-recurring litigation expenses, a foreign currency loss on an exchange rate hedge related to the Bakelite Acquisition, integration costs and incremental non-recurring advisor and external audit fees related to the Bakelite Acquisition and the combinations.

 

(5) Represents estimated net unrealized cost synergies resulting from the Hexion Formation and the Bakelite Acquisition.

 

(6) The Company is required to have an Adjusted EBITDA to Fixed Charges ratio of greater to 2.25 to 1.0 to incur additional indebtedness under certain of our indentures. As of December 31, 2005, the Company was able to satisfy this covenant and incur additional indebtedness under our indentures. In addition, the Company expects to be able to satisfy its Fixed Charges ratio covenant upon the closing of the Akzo Acquisition, which the Company expects to occur in the second quarter of 2006. After giving effect to the Akzo Acquisition, as if it had taken place at the beginning of 2005, Adjusted EBITDA would be $624 (which does not add back the $27 negative cost impact of Hurricanes Katrina and Rita), Fixed Charges would be $214 and the ratio of Adjusted EBITDA to Fixed Charges would be 2.92.

 

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Quantitative and Qualitative Disclosures About Market Risk

 

Risk Management. We use various financial instruments, including some derivatives, to help us hedge our foreign currency exchange risk. We also use raw material purchasing contracts and pricing contracts with customers to mitigate commodity price risks. These contracts generally do not contain minimum purchase requirements.

 

Foreign Exchange Risk. Our international operations accounted for approximately 50% of our sales in 2005 and 49% in 2004. As a result, we have exposure to foreign exchange risk on transactions potentially denominated in many foreign currencies. These transactions include foreign currency denominated imports and exports of raw materials and finished goods (both intercompany and third party) and loan repayments. In all cases, the functional currency is the business unit’s local currency.

 

It is our policy to reduce foreign currency cash flow exposure due to exchange rate fluctuations by hedging firmly committed foreign currency transactions wherever economically feasible. Our use of forward and option contracts is designed to protect our cash flows against unfavorable movements in exchange rates, to the extent of the amount under contract. We do not attempt to hedge foreign currency exposure in a manner that would entirely eliminate the effect of changes in foreign currency exchange rates on net income and cash flow. We do not speculate in foreign currency nor do we hedge the foreign currency translation of our international businesses to the U.S. dollar for purposes of consolidating our financial results or other foreign currency net asset or liability positions. The counter-parties to our forward contracts are financial institutions with investment grade credit ratings.

 

Effective October 11, 2005, we entered into a $289 cross-currency and interest rate swap agreement structured for a non-U.S. subsidiary’s $290 U.S. dollar denominated term loan. The swap is a three-year agreement designed to offset balance sheet and interest rate exposures and cash flow variability associated with exchange rate fluctuations on the term loan. The Euro to U.S. dollar exchange rate under the swap agreement is 1.2038. We pay a variable rate equal to the Euro LIBOR plus 271 basis points. We receive a variable rate equal to the U.S. Dollar LIBOR plus 250 basis points. The amount we receive under this agreement is equal to our non-U.S. subsidiary’s interest rate on its $290 term loan.

 

Our foreign exchange risk is also mitigated because we operate in many foreign countries, reducing the concentration of risk in any one currency. In addition, our foreign operations have limited imports and exports, reducing the potential impact of foreign currency exchange rate fluctuations. With other factors being equal, such as the performance of individual foreign economies, an average 10% foreign exchange increase or decrease in any one country would not materially impact our operating results or cash flow. However, an average 10% foreign exchange increase or decrease in all countries may materially impact our operating results.

 

As required by current accounting standards, our audited Consolidated Statements of Operations includes any gains and losses arising from forward and option contracts.

 

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The following table summarizes our derivative financial instruments as of December 31, 2005 and 2004. Fair values are determined from quoted market prices at these dates.

 

    2005

    2004

 
   

Average

Days

To Maturity


 

Average

Contract

Rate


  Notional
Amount


 

Fair Value

Gain (Loss)


   

Average

Days

To Maturity


 

Average

Contract

Rate


  Notional
Amount


 

Fair Value

Gain (Loss)


 

Currency to sell for Euros

                                   

U.S. Dollars (1)

  27   1.1890   45   —       —     —     —     —    

U.S. Dollars (1)

  990   1.2038   289   5     —     —     —     —    

British Pound (1)

  90   0.6987   41   (1 )   —     —     —     —    

U.S. Dollars (1)

  60   1.2122   3   —       —     —     —     —    

U.S. Dollars (2)

  122   1.2031   24   —       —     —     —     —    

U.S. Dollars (2)

  —     —     —     —       90   1.3430   235   2  

Currency to sell for U.S. Dollars

                                   

Canadian Dollars (3)

  —     —     —     —       183   1.3200   36   —    

Canadian Dollars (4)

  —     —     —     —       183   1.2300   36   (2 )

Currency to sell for CDN Dollars

                                   

British Pound (1)

  —     —     —     —       31   2.3255   42   1  

Commodity Future Contracts

                                   

Natural gas futures

  —     —     3   1     —     —     3   —    

(1) Forward contracts
(2) Deal contingent forward contracts (for pending or completed acquisitions)
(3) Put options purchased
(4) Call options sold

 

Interest Rate Risk. We have used interest rate swaps to minimize our interest rate exposures between fixed and floating rates on long-term debt. We do not enter into speculative financial contracts of any type. The fair values of the swaps are determined using estimated market values. Under interest rate swaps, we agree with other parties to exchange at specified intervals the difference between the fixed rate and floating rate interest amounts calculated by reference to the agreed notional principal amount.

 

Certain of our indebtedness, including indebtedness under our floating rate notes and borrowings under our senior secured credit facilities, are at variable rates of interest and expose us to interest rate risk. If interest rates increase, our debt service obligations on the variable rate indebtedness would increase even though the amount borrowed remained the same. Assuming the amount of variable indebtedness remains the same, an increase of 1% in the interest rates payable on our variable rate indebtedness would increase our fiscal 2006 estimated debt service requirements by approximately $8 million. See “Risk Factors—Risks Relating to Our Business—Our variable-rate indebtedness subjects us to interest rate risk, which could cause our annual debt service obligations to increase significantly.”

 

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Following is a summary of our outstanding debt as of December 31, 2005 and 2004 (See Note 8 to the audited Consolidated Financial Statements for additional information on our debt). The fair value of our publicly held debt is based on the price at which the bonds are traded or quoted at December 31, 2005 and 2004. All other debt fair values are determined from quoted market interest rates at December 31, 2005 and 2004.

 

     2005

   2004

Year


   Debt

  

Weighted
Average

Interest
Rate


    Fair Value

   Debt

  

Weighted
Average

Interest

Rate


    Fair Value

2005

                       $ 17    9.1 %   $ 17

2006

   $ 51    9.1 %   $ 51      4    9.1 %     4

2007

     15    9.2 %     15      4    9.1 %     4

2008

     18    9.2 %     18      5    9.1 %     5

2009

     181    9.2 %     189      175    9.1 %     187

2010

     845    9.3 %     870      801    9.9 %     851

2011 and beyond

     1,244    8.0 %     1,176      844    8.5 %     832
    

        

  

        

     $ 2,354          $ 2,319    $ 1,850          $ 1,900
    

        

  

        

 

We do not use derivative financial instruments in our investment portfolios. We place any cash equivalent investments in instruments that meet the credit quality standards established within our investment policies, which also limit the exposure to any one issue. At December 31, 2005 and 2004, we had $29 and, $72, respectively, invested at average rates of 7% and 2%, respectively, primarily in a prime money market account and marketable securities with maturity periods of 30 days or less. Due to the short maturity of our cash equivalents, the carrying value on these investments approximates fair value and our interest rate risk is not significant. A 10% increase or decrease in interest returns on invested cash would not have a material effect on our net income and cash flows at December 31, 2005 and 2004.

 

Commodity Risk. We are exposed to price risks associated with raw material purchases, most significantly with phenol, methanol, urea, acetone, propylene and chlorine. For our commodity raw materials, we have purchase contracts, with periodic price adjustment provisions. Commitments with certain suppliers, including our phenol and urea suppliers, provide up to 100% of our estimated requirements but also provide the flexibility to purchase a certain percentage of our needs in the spot market, when favorable to us. We rely on long-term agreements with key suppliers for most of our raw materials. The loss of a key source of supply or a delay in shipments could have an adverse effect on business. Should any of our suppliers fail to deliver or should any of the key long-term supply contracts be cancelled, we would be forced to purchase raw materials in the open market, and no assurances can be given that we would be able to make these purchases or make them at prices that would allow us to remain competitive. One supplier provides over 10% of certain raw material purchases, and we could incur significant time and expense if we had to replace the supplier. In addition, several of the feedstocks at various facilities are transported through a pipeline from one supplier. If we were unable to receive these feedstocks through these pipeline arrangements, we may not be able to obtain them from other suppliers at competitive prices or in a timely manner. See “Risk Factors—Risks Relating to Our Business—We rely significantly on raw materials in the production of our products and fluctuations in costs would increase our operating expenses.”

 

Natural gas is essential in our manufacturing processes, and its cost can vary widely and unpredictably. In order to control our costs for natural gas, we hedge a portion of our natural gas purchases for North America by entering into futures contracts for natural gas. The contracts are settled for cash each month based on the closing market price on the last day the contract trades on the New York Mercantile Exchange. We recognize gains and losses on commodity futures contracts each month as gas is used. Our future commitments are marked to market on a quarterly basis. Our board of directors approves all commodity futures contracts that we enter based on delegations of authority.

 

Our commodity risk also is moderated through our selected use of customer contracts with selling price provisions that are indexed to publicly available indices for these commodity raw materials.

 

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Other Matters. Our operations are subject to the usual hazards associated with chemical manufacturing and the related storage and transportation of feedstocks, products and wastes, including, but not limited to, combustion, inclement weather and natural disasters, mechanical failure, unscheduled downtime, transportation interruptions, chemical spills, discharges or releases of toxic or hazardous substances or gases and other environmental risks. These potential hazards could cause personal injury or loss of life, severe damage to or destruction of property and equipment and environmental damage and could result in suspension of our operations and the imposition of civil or criminal penalties. We have significant operational management systems, preventive procedures and protective safeguards to minimize the risk of an incident and to ensure the safe continuous operation of our facilities. In addition, we maintain property, business interruption and casualty insurance that we believe is in accordance with customary industry practices, but we are not fully insured against all potential hazards incidental to our business.

 

Due to the nature of our business and the current litigious climate, product liability litigation, including class action lawsuits claiming liability for death, injury or property damage caused by our products, or by other manufacturers’ products that include our components, is inherent to our business but historically has been immaterial. However, our current product liability claims, and any future lawsuits, could result in damage awards against us, which in turn could encourage additional litigation.

 

Critical Accounting Policies and Estimates

 

In preparing our financial statements in conformity with US GAAP, we have to make estimates and assumptions about future events that affect the amounts of reported assets, liabilities, revenues and expenses, as well as the disclosure of contingent assets and liabilities in the financial statements and accompanying notes. Some of these accounting policies require the application of significant judgment by management in the selection of appropriate assumptions for determining these estimates. By their nature, these judgments are subject to an inherent degree of uncertainty; therefore, we cannot assure you that actual results will not differ significantly from estimated results. We base these judgments on our historical experience, advice from experienced consultants, forecasts and other available information, as appropriate. Our significant accounting policies are more fully described in Note 2 to the audited Consolidated Financial Statements.

 

Our most critical accounting policies, which reflect significant management estimates and judgment in determining reported amounts in the audited Consolidated Financial Statements, are as follows:

 

Environmental Remediation and Restoration Liabilities. Accruals for environmental matters are recorded when we believe it is probable that a liability has been incurred and we can reasonably estimate the amount of the liability. Our accruals are established following the guidelines of Statement of Position 96-1, “Environmental Remediation Liabilities.” We have accrued approximately $39 and $41 at December 31, 2005 and 2004, respectively, for all probable environmental remediation and restoration liabilities, which is our best estimate of these liabilities. Based on currently available information and analysis, we believe that it is reasonably possible that the costs associated with such liabilities may fall within a range of $27 to $79. This estimate of the range of reasonably possible costs is less certain than the estimates upon which reserves are based, and in order to establish the upper limit of this range, we used assumptions that are less favorable to Hexion among the range of reasonably possible outcomes, but we did not assume we would bear full responsibility for all sites, to the exclusion of other potentially responsible parties.

 

We have entered into environmental indemnification agreements with each of the sellers in the Bakelite Transaction, Resolution Performance Transaction and Resolution Specialty Transaction. Under the Bakelite environmental indemnification agreement, the sellers have agreed to indemnify us for certain pre-existing environmental liabilities, including those related to our facility in Duisburg, Germany.

 

For environmental conditions that existed prior to the Resolution Performance Transaction, environmental remediation liability is influenced by agreements associated with the transactions whereby Shell generally will indemnify us for environmental damages associated with environmental conditions that occurred or existed before the closing date of the acquisition, subject to certain limitations. In addition, for incidents occurring after the closing date of the acquisition, management believes that we maintain adequate insurance coverage, subject to deductibles, for environmental remediation activities.

 

According to the terms of the Resolution Specialty Transaction, Eastman retained the liability and indemnified Resolution Specialty for pre-existing unknown environmental conditions at facilities that were transferred to us as well as the pre-existing known environmental conditions at the Roebuck, South Carolina facility, subject to certain limitations.

 

Income Tax Assets and Liabilities. At December 31, 2005 and 2004, we had valuation allowances of $239 and $192, respectively, against all of our net federal and state and some of our net foreign deferred income tax assets. The valuation allowance was calculated in accordance with US GAAP which requires an assessment of both negative and positive evidence when measuring the need for a valuation allowance. In accordance with SFAS 109, evidence, such as operating results during the most recent three-year period, is given more weight than our expectations of future profitability, which are inherently uncertain. Our losses in the U.S. and certain foreign operations in recent periods represented sufficient negative evidence to require a full valuation allowance against our net federal, state and certain of our foreign deferred income tax assets. We intend to maintain a valuation allowance against the net deferred income tax assets until sufficient positive evidence exists to support the realization of such assets.

 

        The calculation of our income tax liabilities involves dealing with uncertainties in the application of complex domestic and foreign income tax regulations. We recognize liabilities for anticipated income tax audit issues based on our estimate of whether, and the extent to which, additional income taxes will be due. If we ultimately determine that payment of these amounts is not necessary, we reverse the liability and recognize an income tax benefit during the period in which we determine that the liability is no longer necessary. We also recognize income tax benefits to the extent that it is probable that our positions will be sustained when challenged by the respective taxing authorities. To the extent we prevail in matters for which liabilities have been established, or are required to pay amounts in excess of our liabilities, our effective income tax rate in a given period could be materially impacted. An unfavorable income tax settlement would require use of the Company’s cash and result in an increase in its effective income tax rate in the year of resolution. A favorable income tax settlement would be recognized as a reduction in the effective income tax rate in the year of resolution.

 

Pension Assets and Liabilities. The amounts recognized in our financial statements related to pension benefit obligations are determined from actuarial valuations. Inherent in these valuations are certain assumptions, the more significant of which include:

 

    The weighted average rate to use for discounting the liability 5.0% for 2005 and 5.4% for 2004;

 

    The weighted average expected long-term rate of return on pension plan assets 8.2% for 2005 and 2004;

 

    The weighted average rate of future salary increases 3.6% for 2005 and 4.1% for 2004; and

 

    The anticipated mortality rate table (used RP 2000 Table).

 

The actual return of our pension plan assets in 2005 was approximately 10%. Future returns on plan assets are subject to the strength of the financial markets, which we cannot predict with any accuracy. These assumptions are regularly reviewed and revised when appropriate, and changes in one or more of them could affect the amount of our recorded net expenses and/or liabilities related to these pension obligations. Other assumptions involving demographic factors such as mortality, retirement age and turnover are also evaluated periodically and updated to reflect our experience and expectations for the future. Actual results that differ from our assumptions are accumulated and amortized over future periods; therefore, these variances affect our expenses and obligations recorded in future periods. Future pension expense and required contributions will also depend on future investment performance, changes in future discount rates and various other factors related to the demographic characteristics of participants in our pension plans.

 

Long-Lived Assets and Depreciation and Amortization. With respect to long-lived assets, key assumptions include the estimate of useful lives and the recoverability of carrying values of fixed assets, and other intangible assets. The recovery of assets to be held and used is measured by a comparison of the carrying amount of an asset to future undiscounted net cash flows expected to be generated by the asset, which is subject to considerable judgment. If the useful lives of the assets were found to be shorter than originally estimated, depreciation and amortization charges would be accelerated.

 

Impairment of Long-Lived Assets. As events warrant, the Company evaluates the recoverability of long-lived assets by assessing whether the carrying value can be recovered over their remaining useful lives through the expected future undiscounted operating cash flows of the underlying business. Any impairment loss required is determined by comparing the carrying value of the assets to operating cash flows on a discounted basis.

 

Recently Issued Accounting Standards

 

In November 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 151, Inventory Costs. The statement amends Accounting Research Bulletin (“ARB”) No. 43, Inventory Pricing, to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material. ARB No. 43 previously stated that these costs must be “so abnormal as to require treatment as current-period charges.” SFAS No. 151 requires that those items be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal.” In addition, this statement requires that allocation of fixed production overhead to the costs of conversion be based on the normal capacity of the production facilities. The statement is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company believes that implementing SFAS No. 151 should not have a material impact on its consolidated financial position, results of operations or cash flows.

 

In March 2005, the FASB issued Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations, an interpretation of FASB Statement No. 143. This Interpretation clarifies that the term “conditional asset retirement obligation” as used in FASB No. 143, Accounting for Asset Retirement Obligations, refers to a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity. Accordingly, an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation, when incurred, if the fair value of the liability can be reasonably estimated. The Interpretation is effective for the Company no later than the end of the fiscal year ending on December 31, 2005. The implementation of this Interpretation did not have a material effect on the Company’s consolidated financial position, results of operations or cash flows.

 

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In September 2005, the FASB issued EITF Issue No. 04-13, Accounting for Purchases and Sales of Inventory with the Same Counterparty (“EITF 04-13”). The issue provided guidance on the circumstances under which two or more inventory transactions with the same counterparty should be viewed as a single nonmonetary transaction within the scope of APB Opinion No. 29, Accounting for Nonmonetary Transactions. The issue also provided guidance on circumstances under which nonmonetary exchanges of inventory within the same line of business should be recognized at fair value. EITF 04-13 will be effective for transactions completed in reporting periods beginning after March 15, 2006. The Company is evaluating the impact that this issue will have on our consolidated financial statements.

 

In November 2005, the FASB issued FSP FAS 123(R)-3, Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards (“FSP 123(R)-3”). FSP 123(R)-3 provides an elective alternative method that establishes a computational component to arrive at the beginning balance of the accumulated paid-in capital pool related to employee compensation and a simplified method to determine the subsequent impact on the accumulated paid-in capital pool of employee awards that are fully vested and outstanding upon the adoption of SFAS No. 123(R). We are currently evaluating this transition method.

 

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ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Refer to the “Quantitative and Qualitative Disclosures About Market Risk” section included in Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operation.

 

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Table of Contents
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

Index to Consolidated Financial Statements

 

     Page
Number


Consolidated Financial Statements of Hexion Specialty Chemicals, Inc.

    

Consolidated Statements of Operations:
For the years ended December 31, 2005, 2004 and 2003

   71

Consolidated Balance Sheets:
As of December 31, 2005 and 2004

   72

Consolidated Statements of Cash Flows:
For the years ended December 31, 2005, 2004 and 2003

   74

Consolidated Statements of Common Stock and Other Shareholder’s (Deficit) Equity:
For the years ended December 31, 2005, 2004 and 2003

   75

Notes to Consolidated Financial Statements:
For the years ended December 31, 2005, 2004 and 2003

   76

Reports of Independent Registered Public Accounting Firms

   131

Financial Statement Schedule:

    

Schedule II - Valuation and Qualifying Accounts

   133

 

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HEXION SPECIALTY CHEMICALS, INC.

 

CONSOLIDATED STATEMENTS OF OPERATIONS

 

     Year Ended December 31,

 
     2005

    2004

    2003

 
     (In millions, except share and per share data)  

Net sales

   $ 4,470     $ 2,019     $ 782  

Cost of sales

     3,808       1,785       714  
    


 


 


Gross profit

     662       234       68  
    


 


 


Selling, general & administrative expense

     400       163       81  

Transaction related costs (See Note 1)

     44       56       —    

Other operating expense

     10       6       10  
    


 


 


Operating income (loss)

     208       9       (23 )
    


 


 


Interest expense, net

     204       117       77  

Write-off of deferred financing fees (See Note 8)

     17       —         —    

Other non-operating expense, net

     16       5       —    
    


 


 


Loss from continuing operations before income tax, earnings from unconsolidated entities and minority interest

     (29 )     (113 )     (100 )

Income tax expense (benefit) (See Note 16)

     48       —         (37 )
    


 


 


Loss from continuing operations before earnings from unconsolidated entities and minority interest

     (77 )     (113 )     (63 )

Earnings from unconsolidated entities, net of taxes

     2       —         —    

Minority interest in net (income) loss of consolidated subsidiaries

     (3 )     8       13  
    


 


 


Loss from continuing operations

     (78 )     (105 )     (50 )
    


 


 


Loss from discontinued operations (See Note 4)

     9       —         —    
    


 


 


Net loss

     (87 )     (105 )     (50 )

Redeemable preferred stock accretion (See Note 11)

     30       —         —    
    


 


 


Net loss available to common shareholders

   $ (117 )   $ (105 )   $ (50 )
    


 


 


Comprehensive loss

   $ (172 )   $ (36 )   $ (9 )
    


 


 


Basic and Diluted Per Share Data

                        

Loss from continuing operations

   $ (1.30 )   $ (1.27 )   $ (0.61 )

Loss from discontinued operations

     (0.11 )     —         —    
    


 


 


Net loss available to common shareholders

   $ (1.41 )   $ (1.27 )   $ (0.61 )
    


 


 


Dividends (See Note 14)

   $ 6.66     $ —       $ —    
    


 


 


Average number of common shares outstanding during the period— basic and diluted

     82,629,906       82,629,906       82,629,906  

 

See Notes to Consolidated Financial Statements

 

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HEXION SPECIALTY CHEMICALS, INC.

 

CONSOLIDATED BALANCE SHEETS

 

     December 31,
2005


    December 31,
2004


 
     (In millions)  

ASSETS

                

Current Assets

                

Cash and equivalents

   $ 183     $ 152  

Accounts receivable (less allowance for doubtful accounts of $19 in 2005 and $15 in 2004)

     605       518  

Inventories:

                

Finished and in-process goods

     292       290  

Raw materials and supplies

     153       115  

Other current assets

     132       64  
    


 


       1,365       1,139  
    


 


Other Assets

     103       95  
    


 


Property and Equipment

                

Land

     63       44  

Buildings

     209       201  

Machinery and equipment

     1,777       1,706  
    


 


       2,049       1,951  

Less accumulated depreciation

     (653 )     (628 )
    


 


       1,396       1,323  

Goodwill (See Note 6)

     169       51  

Other Intangible Assets, net (See Note 6)

     176       88  
    


 


Total Assets

   $ 3,209     $ 2,696  
    


 


 

See Notes to Consolidated Financial Statements

 

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HEXION SPECIALTY CHEMICALS, INC.

 

CONSOLIDATED BALANCE SHEETS

 

     December 31,

    December 31,

 
     2005

    2004

 
     (In millions, except share and
per share data)
 

LIABILITIES, REDEEMABLE PREFERRED STOCK, COMMON STOCK AND OTHER SHAREHOLDER’S DEFICIT

                

Current Liabilities

                

Accounts and drafts payable

   $ 503     $ 488  

Debt payable within one year

     51       16  

Interest payable

     45       36  

Income taxes payable

     91       33  

Other current liabilities

     248       133  
    


 


       938       706  
    


 


Other Liabilities

                

Long-term debt

     2,303       1,834  

Long-term pension obligations

     167       73  

Non-pension postemployment benefit obligations

     119       142  

Deferred income taxes

     139       131  

Other long-term liabilities

     92       65  
    


 


       2,820       2,245  
    


 


Minority interest in consolidated subsidiaries

     11       54  

Commitments and Contingencies (See Notes 8 and 10)

                

Redeemable Preferred Stock - $0.01 par value; liquidation preference $25 per share; 60,000,000 shares authorized, 14,781,959 issued and outstanding at December 31, 2005 (See Note 11)

     364       —    

Common Stock and Other Shareholder’s Deficit

                

Common stock - $0.01 par value; 300,000,000 shares authorized,

                

170,678,965 issued, 88,049,059 treasury and 82,629,906 outstanding at December 31, 2005 and 2004

     1       1  

Paid-in capital

     515       1,523  

Treasury stock

     (296 )     (296 )

Receivable from parent

     —         (561 )

Accumulated other comprehensive (loss) income

     (70 )     20  

Accumulated deficit

     (1,074 )     (996 )
    


 


       (924 )     (309 )
    


 


Total Liabilities, Redeemable Preferred Stock, Common Stock and Other Shareholder’s Deficit

   $ 3,209     $ 2,696  
    


 


 

See Notes to Consolidated Financial Statements

 

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HEXION SPECIALTY CHEMICALS, INC.

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

    Year ended
December 31,


 
    2005

    2004

    2003

 
    (In millions)  

Cash Flows from (used in) Operating Activities

                       

Net loss

  $ (87 )   $ (105 )   $ (50 )

Adjustments to reconcile net loss to net cash from (used in) operating activities:

                       

Depreciation and amortization

    148       86       58  

Minority interest in net income (loss) of consolidated subsidiaries

    3       (8 )     (13 )

Stock-based compensation (See Note 15)

    12       4       —    

Deferred tax benefit

    (3 )     (3 )     (37 )

Unrealized foreign exchange loss

    13       —         —    

Amortization of deferred financing fees

    9       5       10  

Write-off of deferred financing fees (See Note 8)

    11       —         —    

Non-cash restructuring

    9       —         —    

Impairments

    8       2       13  

Other non-cash adjustments

    (3 )     —         (5 )

Net change in assets and liabilities:

                       

Accounts receivable

    7       (81 )     9  

Inventories

    59       (53 )     10  

Accounts and drafts payable

    (29 )     133       (46 )

Income taxes payable

    58       —         10  

Other assets

    (50 )     (20 )     4  

Other liabilities

    6       8       (6 )
   


 


 


      171       (32 )     (43 )
   


 


 


Cash Flows (used in) from Investing Activities

                       

Capital expenditures

    (105 )     (57 )     (18 )

Acquisition of businesses, net of cash acquired

    (252 )     (152 )     —    

Proceeds from the sale of business, net of cash

    3       —         —    

Cash combination of Borden Chemical

    —         185       —    

Proceeds from the sale of assets

    —         4       23  

Distributions from equity affiliates

    —         —         2  
   


 


 


      (354 )     (20 )     7  
   


 


 


Cash Flows from (used in) Financing Activities

                       

Net short-term debt repayments

    (2 )     (6 )     —    

Borrowings of long-term debt

    1,193       293       748  

Repayments of long-term debt

    (750 )     (195 )     (645 )

Payment of dividends

    (523 )     —         —    

Proceeds from the issue of preferred stock, net of issuance costs (See Note 11)

    334       —         —    

Long-term debt and credit facility financing fees paid

    (22 )     —         —    

IPO related costs (See Note 1)

    (11 )     —         —    

Proceeds related to Resolution Specialty Transaction

    —         60       —    

Other

    —         (4 )     (23 )
   


 


 


      219       148       80  
   


 


 


Effect of exchange rates on cash and equivalents

    (5 )     7       1  
   


 


 


Increase in cash and equivalents

    31       103       45  

Cash and equivalents at beginning of year

    152       49       4  
   


 


 


Cash and equivalents at end of year

  $ 183     $ 152     $ 49  
   


 


 


Supplemental Disclosures of Cash Flow Information

                       

Cash paid (received):

                       

Interest, net

  $ 192     $ 102     $ 63  

Income taxes, net

    8       3       (19 )

Non-cash activity:

                       

Settlement of note receivable from parent

    581       —         —    

Unpaid common stock dividends declared

    27       —         —    

Redeemable preferred stock accretion (See Note 11)

    30       —         —    

Reclassification of minimum pension liability adjustment (to) from shareholder’s deficit

    (16 )     2       —    

Issuance of Note in Resolution Specialty Transaction

    —         50       —    

 

See Notes to Consolidated Financial Statements

 

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HEXION SPECIALTY CHEMICALS, INC.

 

CONSOLIDATED STATEMENT OF COMMON STOCK AND OTHER SHAREHOLDER’S (DEFICIT) EQUITY

 

    Common
Stock


  Paid-in
Capital


    Treasury
Stock


    Receivable
from
Parent


   

Accumulated

Other
Comprehensive
(Loss) Income


    Accumulated
(Deficit)
Equity


    Total

 
    (In millions)  

Balance, December 31, 2002

  $ 1   $ 143     $ —       $ —       $ 41     $ (22 )   $ 163  
   

 


 


 


 


 


 


Net loss

    —       —         —         —         —         (50 )     (50 )

Translation adjustments

    —       —         —         —         40       —         40  

Interest rate swap, net of tax

    —       —         —         —         1       —         1  
                                                 


Comprehensive loss

    —       —         —         —         —         —         (9 )
                                                 


Constructive distribution

    —       —         —         —         —         (2 )     (2 )
   

 


 


 


 


 


 


Balance, December 31, 2003

  $ 1   $ 143       —         —       $ 82     $ (74 )   $ 152  
   

 


 


 


 


 


 


Net loss

    —       —         —         —         —         (105 )     (105 )

Translation adjustments

    —       —         —         —         67       —         67  

Minimum pension liability adjustment, net of tax

    —       —         —         —         2       —         2  
                                                 


Comprehensive loss

    —       —         —         —         —         —         (36 )
                                                 


Acquisition of Resolution Specialty to Consolidated group

    —       57       —         —         —         —         57  

Acquisition of Borden Chemical to Consolidated group

    —       1,252       (296 )     (542 )     (131 )     (817 )     (534 )

Interest accrued on notes from parent of Borden Chemical

    —       19       —         (19 )     —         —         —    

Compensation expense under deferred compensation plan

    —       4       —         —         —         —         4  

Deferred tax adjustments as a result of Combination

    —       48       —         —         —         —         48  
   

 


 


 


 


 


 


Balance, December 31, 2004

  $ 1   $ 1,523     $ (296 )   $ (561 )   $ 20     $ (996 )   $ (309 )
   

 


 


 


 


 


 


Net loss

    —       —         —         —         —         (87 )     (87 )

Translation adjustments

    —       —         —         —         (69 )     —         (69 )

Minimum pension liability adjustment, net of tax of $8

    —       —         —         —         (16 )     —         (16 )
                                                 


Comprehensive loss

                                                  (172 )
                                                 


Effect of Combinations (See Note 14)

    —       (581 )     —         581       —         —         —    

Purchase accounting related to acquisition of minority interest (See Note 3)

    —       121       —         —         (5 )     11       127  

Dividends declared (See Note 11)

    —       (550 )     —         —         —         —         (550 )

Stock based compensation expense (See Note 15)

    —       12       —         —         —         —         12  

Redeemable preferred stock accretion (See Note 11)

    —       (30 )     —         —         —         —         (30 )

Interest accrued on notes from parent of Borden Chemical (See Note 14)

    —       20       —         (20 )     —         —         —    

Other

    —       —         —         —         —         (2 )     (2 )
   

 


 


 


 


 


 


Balance, December 31, 2005

  $ 1   $ 515     $ (296 )   $ —       $ (70 )   $ (1,074 )   $ (924 )
   

 


 


 


 


 


 



(a) Accumulated other comprehensive loss at December 31, 2005 represents $27 of net foreign currency translation gains, a $5 net loss from purchase accounting adjustments related to the acquisition of minority interests and a $92 net loss relating to the Company’s minimum pension liability adjustment. Accumulated other comprehensive income at December 31, 2004 represents $96 of net foreign currency translation gains and a $76 net loss relating to the Company’s minimum pension liability adjustment. Accumulated other comprehensive income at December 31, 2003 represents $82 of net foreign currency translation gains.

 

See Notes to Consolidated Financial Statements

 

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Table of Contents

HEXION SPECIALTY CHEMICALS, INC.

 

Notes to Consolidated Financial Statements

(In millions, except share and per share data)

 

1. Background and Basis of Presentation

 

Hexion Specialty Chemicals, Inc. (“Hexion” or “the Company”) is engaged in the manufacture and marketing of resins, inks, coating and adhesive resins, formaldehyde, oil field products and other specialty and industrial chemicals worldwide. At December 31, 2005, the Company has 86 production and manufacturing facilities, of which 37 are located in the U.S. Hexion was formed on May 31, 2005 upon the combination of three Apollo Management, L.P. (“Apollo”) controlled companies (the “Combinations”), Resolution Performance Products, LLC (“Resolution Performance”), Resolution Specialty Materials, Inc. (“Resolution Specialty Inc.”) and Borden Chemical, Inc. (“Borden Chemical”). Apollo acquired Resolution Performance on November 14, 2000, formed Resolution Specialty Inc. and purchased the Specialty Resins and Monomers and Ink business of Eastman Chemical Company (“Eastman”) on August 2, 2004 through a subsidiary (the “Resolution Specialty Transaction”), Resolution Specialty Materials, LLC (“Resolution Specialty”), and acquired Borden Chemical on August 12, 2004. Upon consummation of the Combinations, Borden Chemical changed its name to Hexion Specialty Chemicals, Inc., and BHI Acquisition LLC (“BHI Acquisition”), Borden Chemical’s parent, changed its name to Hexion LLC. Prior to the Combinations, on April 29, 2005, a subsidiary of Borden Chemical completed its acquisition of Bakelite Aktiengesellschaft (“Bakelite”) (See Note 3).

 

The Company has incurred costs totaling approximately $44 in connection with the Combinations and terminated acquisition activities during the year ended December 31, 2005, primarily for accounting, consulting, legal and contract termination fees. As this transaction is considered a merger of entities under common control, in accordance with Financial Accounting Standard Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 141, Business Combinations, these costs have been expensed as incurred and are included in the 2005 Consolidated Statement of Operations as Transaction related costs.

 

In the 2004, as a result of the acquisitions of Resolution Specialty and Borden Chemical by Apollo, the Company incurred Transaction related costs of $56. This amount included charges for accounting and legal fees, fees paid to Apollo, payments for cancellation of restricted stock and management bonuses pertaining to the activity.

 

On April 25, 2005, the Company filed a registration statement, which is not yet effective, with the U.S. Securities and Exchange Commission (the “SEC”) for a proposed IPO of its common stock. The Company subsequently filed six amendments to its registration statement on May 2, 2005, June 13, 2005, July 15, 2005, August 26, 2005, September 19, 2005 and November 21, 2005.

 

The Company has incurred costs totaling approximately $11 in connection with the proposed IPO during the year ended December 31, 2005, primarily for accounting and legal fees and printing costs. As the costs of issuing common stock are considered a reduction of the related proceeds of the offering, these costs have been deferred within Other assets on the December 31, 2005 Consolidated Balance Sheet until the IPO is effected.

 

Basis of Presentation—Prior to the Combinations, Resolution Performance, Resolution Specialty Inc. and Borden Chemical were considered entities under the common control of Apollo affiliates as defined in Emerging Issues Task Force (“EITF”) Issue No. 02-5, Definition of Common Control in Relation to FASB Statement of Financial Accounting Standards No. 141, “Business Combinations”. As a result of the Combinations, the financial statements of these entities are presented retroactively on a consolidated basis, in a manner similar to a pooling of interests, and include the results of operations of each business only from the date of acquisition by the Apollo affiliates.

 

The accompanying Hexion Consolidated Financial Statements include the following entities: the former Resolution Performance and its majority-owned subsidiaries as of December 31, 2005 and 2004 and for the years ended

 

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Table of Contents

HEXION SPECIALTY CHEMICALS, INC.

 

Notes to Consolidated Financial Statements—(Continued)

(In millions, except share and per share data)

 

December 31, 2005, 2004 and 2003; the former Resolution Specialty Inc. and its majority-owned subsidiaries as of December 31, 2005 and 2004, for the year ended December 31, 2005, and from the date of acquisition for 2004; and the former Borden Chemical and its majority-owned subsidiaries (which includes Bakelite since the date of acquisition) as of December 31, 2005 and 2004, for the year ended December 31, 2005, and from the date of acquisition in 2004. Resolution Performance, Resolution Specialty, Inc. and Bakelite reflect the purchase method of accounting. Borden Chemical elected not to apply push-down accounting because it was a public reporting registrant as a result of public debt that was outstanding prior and subsequent to the acquisition by Apollo.

 

 

2. Summary of Significant Accounting Policies

 

Significant accounting policies followed by the Company, as summarized below, are in conformity with generally accepted accounting principles.

 

Principles of Consolidation—The Consolidated Financial Statements include the accounts of Resolution Performance, Resolution Specialty Inc., Borden Chemical and Bakelite and their majority-owned subsidiaries, in which no substantive participating rights are held by minority shareholders, after elimination of intercompany accounts and transactions. The Company’s share of the net earnings of 20% to 50% owned companies, for which it has the ability to exercise significant influence over operating and financial policies, are included in income on an equity basis. Investments of other companies are carried at cost.

 

The Company has a 50% ownership interest in two joint venture companies that produce formaldehyde, resins and UV-curable coatings and adhesives in China. The joint ventures are accounted for using the equity method of accounting for investments. However, as the Company does not have the ability to exercise significant influence over the operating and financial policies, the Company’s share of net earnings are presented as Earnings from unconsolidated entities on the Consolidated Statements of Operations.

 

The Company has recorded a minority interest for the equity interests in subsidiaries that are not 100% owned by the Company. At December 31, 2004, the minority interest primarily reflected the equity interest in Resolution Performance and Resolution Specialty held by management and other third-parties. On May 31, 2005, the Resolution Performance and Resolution Specialty minority interests were purchased in connection with the Combinations and recorded as a step acquisition (See Note 3). At December 31, 2005, the minority interest primarily reflects the Company’s ownership interest in HA-International, LLC (“HAI”), a joint venture between the Company and Delta-HA, Inc.

 

Use of Estimates—The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. The most significant estimates reflected in the financial statements include environmental remediation, legal liabilities, deferred tax assets and liabilities and related valuation allowances, income tax accruals, pension and postretirement assets and liabilities, valuation allowances for accounts receivable and inventories, general insurance liabilities, asset impairments, and fair values of assets acquired and liabilities assumed in business acquisitions. Actual results could differ from estimated amounts.

 

Cash and Equivalents—The Company considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents. At December 31, 2005 and 2004, the Company had interest bearing time deposits and other cash equivalent investments of $29 and $72, respectively, included on the Consolidated Balance Sheets as Cash and equivalents.

 

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HEXION SPECIALTY CHEMICALS, INC.

 

Notes to Consolidated Financial Statements—(Continued)

(In millions, except share and per share data)

 

Inventories—Inventories are stated at lower of cost or market. Cost is determined using the first-in, first-out method.

 

Property and Equipment—Land, buildings and machinery and equipment are valued at cost. Depreciation is recorded on the straight-line basis by charges to expense at rates based on estimated useful lives of properties (average estimated useful life for buildings is 20 years; average useful life for machinery and equipment is 15 years). Major renewals and betterments are capitalized. Maintenance, repairs and minor renewals are expensed as incurred. Depreciation expense was $136, $81 and $54 for the years ended December 31, 2005, 2004 and 2003, respectively.

 

Deferred Expenses—Deferred financing costs are classified as Other assets on the Consolidated Balance Sheets and are amortized over the life of the related debt or credit facility using the straight-line method since no installment payments are required. Upon retirement of any of the related debt, a proportional share of debt issuance costs is expensed. At December 31, 2005 and 2004, the Company’s unamortized deferred financing costs were $54 and $54, respectively. See Note 8.

 

Goodwill and Intangibles—The excess of purchase price over net tangible and identifiable intangible assets of businesses acquired is carried as Goodwill on the Consolidated Balance Sheets. The Company does not amortize goodwill or indefinite-lived intangible assets. Separately identifiable intangible assets used in the operations of the business (e.g., formulae and technology, customer lists and contracts, etc.) are recorded at cost and carried as Other intangible assets on the Consolidated Balance Sheets. Intangible assets with determinable lives are amortized on a straight-line basis over the shorter of the legal or useful life of the asset, which ranges from 4 to 30 years. See Note 6.

 

Impairment—As events warrant, the Company evaluates the recoverability of long-lived assets by assessing whether the carrying value of the assets can be recovered over their remaining useful lives through the expected future undiscounted operating cash flows of the underlying business. Any impairment loss required is determined by comparing the carrying value of the assets to operating cash flows on a discounted basis.

 

The Company performs an annual impairment test for goodwill and indefinite-lived intangible assets. See Note 6.

 

General Insurance—The Company is generally self-insured for losses and liabilities relating to workers’ compensation, health and welfare claims, physical damage to property, business interruption and comprehensive general, product and vehicle liability but maintains insurance policies for certain items exceeding deductible limits. Losses are accrued for the estimated aggregate liability for claims using certain actuarial assumptions followed in the insurance industry and the Company’s experience. The Company maintains a liability for certain self-insured claims incurred but not yet recorded, based on actuarial estimates. The Company’s reserves for self-insurance totaled $6 and $4 at December 31, 2005 and 2004, respectively.

 

Legal Costs—The Company accrues for legal costs in the period in which a claim is made or an event becomes known, if the amounts are probable and reasonably estimable. Each claim is assigned a range of potential liability, with the most likely amount being accrued. The amount accrued includes all costs associated with a claim, including settlements, assessments, judgments, fines and legal fees.

 

Revenue Recognition—Revenue for product sales, net of estimated allowances and returns, is recognized as risk and title to the product transfer to the customer, which either occurs at the time shipment is made or upon delivery. In situations where product is delivered by pipeline, risk and title transfers when the product moves

 

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HEXION SPECIALTY CHEMICALS, INC.

 

Notes to Consolidated Financial Statements—(Continued)

(In millions, except share and per share data)

 

across an agreed transfer point, which is typically the customers’ property line. Product sales delivered by pipeline are measured based on daily flow meter readings. The Company’s standard terms of delivery are included in its contracts of sale and invoices.

 

Shipping and Handling—The Company records freight billed to customers in net sales. Shipping costs are incurred to move the Company’s products from production and storage facilities to the customer. Handling costs are incurred from the point the product is removed from inventory until it is provided to the shipper and generally include costs to store, move and prepare the products for shipment. Shipping and handling costs are recorded in Cost of sales in the Consolidated Statements of Operations.

 

Research and Development Costs—Funds are committed to research and development for technical improvement of products and processes that are expected to contribute to operating profits in future years. All costs associated with research and development are charged to expense as incurred. Research and development and technical service expenditures were $62, $30 and $16 for the years ended December 31, 2005, 2004 and 2003, respectively.

 

Foreign Currency Translations—Assets and liabilities of foreign affiliates are translated at the exchange rates in effect at the balance sheet date, and income and expenses are translated at average exchange rates prevailing during the year. The effect of translation is accounted for as an adjustment to Common Stock and Other Shareholder’s Equity (Deficit) and is included in Other comprehensive income (loss).

 

Income Taxes—The Company provides for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes”. SFAS 109 requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial statement carrying amounts and the tax bases of the assets and liabilities. See Note 16.

 

Deferred tax balances are adjusted to reflect tax rates, based on current tax laws, that will be in effect in the years in which temporary differences are expected to reverse. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. See Note 16.

 

Derivative Financial Instruments—The Company is party to forward exchange contracts and options, interest rate swaps, cross-currency swaps and natural gas futures to reduce its cash flow exposure to changes in foreign exchange rates and natural gas prices. The Company does not hold or issue derivative financial instruments for trading purposes. These instruments are not accounted for using hedge accounting, but are measured at fair value and recorded on the balance sheet as an asset or liability, depending upon the Company’s underlying rights or obligations. See Note 7.

 

Loss Per Share—As a result of the Combinations, the Company’s capital structure consists of 82,629,906 shares outstanding (See Note 14). For purposes of calculating loss per share, 82,629,906 was used as the number of outstanding shares for all periods presented as no new shares were issued as a result of the legal merger of Resolution Performance, Resolution Specialty and Borden Chemical. This presentation reflects the post-merger capital structure of the Company for all periods on a consistent basis. The Company did not have any potentially dilutive instruments outstanding for any periods.

 

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HEXION SPECIALTY CHEMICALS, INC.

 

Notes to Consolidated Financial Statements—(Continued)

(In millions, except share and per share data)

 

The Company’s loss per share is calculated as follows:

 

     Year ended December 30,

 
     2005

    2004

    2003

 

Loss from continuing operations

   $ (78 )   $ (105 )   $ (50 )

Deduct: Redeemable preferred stock accretion

     (30 )     —         —    
    


 


 


Loss from continuing operations available to common shareholders

   $ (108 )   $ (105 )   $ (50 )
    


 


 


Per share - Loss from continuing operations available to common shareholders

   $ (1.30 )   $ (1.27 )   $ (0.61 )
    


 


 


Average number of common shares outstanding during the period - basic and diluted

     82,629,906       82,629,906       82,629,906  

 

Stock-Based Compensation—Effective January 1, 2005, the Company elected to adopt SFAS No. 123(R) (revised 2004), Share-Based Payment. Under the provisions of SFAS No. 123(R), stock-based compensation cost is measured at the grant date based on the value of the award and is recognized as expense over the requisite service period. As the Company was considered a nonpublic entity, at the date of adoption, that used the minimum value method for pro forma disclosures under SFAS No. 123, Accounting for Stock-Based Compensation, the Company is required to apply the prospective transition method. As such, the Company applies the statement to any new awards and to any awards modified, repurchased or cancelled since January 1, 2005. The adoption of SFAS No. 123(R) had no initial impact on the Company’s financial condition and results of operations.

 

Previously, the Company accounted for stock based awards under APB No. 25 and applied the minimum value method to determine fair value for disclosure requirements under SFAS No. 123. As of December 31, 2005, all awards outstanding are accounted for under SFAS No. 123(R). See Note 15.

 

The following tables sets forth the required reconciliation of reported and proforma net loss and earnings per share (“EPS”) under SFAS No. 148:

 

     Year ended December 31,

 
     2004

    2003

 

Net loss, as reported

   $ (105 )   $ (50 )
    


 


Add: Stock-based employee compensation expense included in reported net income, net of related tax effects

     8       —    

Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effect

     (6 )     —    
    


 


Pro forma net loss

   $ (103 )   $ (50 )
    


 


Average number of common shares outstanding—basic and diluted

     82,629,906       82,629,906  

Per share, as reported (basic and diluted)

   $ (1.27 )   $ (0.61 )

Per share, pro forma (basic and diluted)

   $ (1.25 )   $ (0.61 )

 

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Table of Contents

HEXION SPECIALTY CHEMICALS, INC.

 

Notes to Consolidated Financial Statements—(Continued)

(In millions, except share and per share data)

 

To determine pro forma compensation cost for the plans in accordance with SFAS No. 123, the fair value of each option grant was estimated at the date of the grant using the minimum value method and the Black-Scholes options pricing model with the following weighted average rates, dividend rates and expected lives for each of the Company’s respective plans:

 

     2004

    2003

 
     Resolution
Performance


    Resolution
Specialty


    Borden
Chemical


    Resolution
Performance


 

Risk-free weighted average interest rate

     4.50 %     3.90 %     3.54 %     4.23 %

Dividend Rate

     0 %     0 %     0 %     0 %

Expected life

     7.0 years       6.3 years       5.0 years       6.0 years  

Estimated fair value of option grants (a)

   $ —       $ 0.77     $ 1.01     $ —    

(a) Fair value of option grants reflects the post-combination equivalent Hexion LLC common units giving effect to the reverse split (Note 15)

 

Concentrations of Credit Risk—Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of temporary cash investments and accounts receivable. The Company places its temporary cash investments with high quality institutions and, by policy, limits the amount of credit exposure to any one institution. At December 31, 2005 and 2004, investments included $0 and $52, respectively, in a prime money market account, $0 and $18, respectively, in a guaranteed investment certificate and $29 and $3 of other marketable securities. Remaining cash is held in several financial institutions. Concentrations of credit risk with respect to accounts receivable are limited, due to the large number of customers comprising the Company’s customer base and their dispersion across many different industries and geographies. The Company generally does not require collateral or other security to support customer receivables. See Note 7.

 

Concentrations of Supplier Risk—The Company relies on long-term agreements with key suppliers for most of its raw materials. The loss of a key source of supply or a delay in shipments could have an adverse effect on business. Should any of the suppliers fail to deliver or should any of the key long-term supply contracts be cancelled, the Company would be forced to purchase raw materials in the open market, and no assurances can be given that the Company would be able to make these purchases or make them at prices that would allow it to remain competitive. One supplier provides over 10% of certain raw material purchases, and we could incur significant time and expense if we had to replace the supplier. In addition, several of the feedstocks at various facilities are transported through a pipeline from one supplier. If we were unable to receive these feedstocks through these pipeline arrangements, the Company may not be able to obtain them from other suppliers at competitive prices or in a timely manner.

 

Recently Issued Accounting Standards

 

In November 2004, the FASB issued SFAS No. 151, Inventory Costs. The statement amends Accounting Research Bulletin (“ARB”) No. 43, Inventory Pricing, to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material. ARB No. 43 previously stated that these costs must be “so abnormal as to require treatment as current-period charges.” SFAS No. 151 requires that those items be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal.” In addition, this statement requires that allocation of fixed production overhead to the costs of conversion be based on the normal capacity of the production facilities. The statement is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company believes that implementing SFAS No. 151 should not have a material impact on its consolidated financial position, results of operations or cash flows.

 

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HEXION SPECIALTY CHEMICALS, INC.

 

Notes to Consolidated Financial Statements—(Continued)

(In millions, except share and per share data)

 

In March 2005, the FASB issued Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations, an interpretation of FASB Statement No. 143. This Interpretation clarifies that the term “conditional asset retirement obligation” as used in FASB No. 143, Accounting for Asset Retirement Obligations, refers to a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity. Accordingly, an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation, when incurred, if the fair value of the liability can be reasonably estimated. The Interpretation is effective for the Company no later than the end of the fiscal year ending on December 31, 2005. The implementation of this Interpretation did not have a material effect on the Company’s consolidated financial position, results of operations or cash flows.

 

In September 2005, the FASB issued EITF Issue No. 04-13, Accounting for Purchases and Sales of Inventory with the Same Counterparty (“EITF 04-13”). The issue provided guidance on the circumstances under which two or more inventory transactions with the same counterparty should be viewed as a single nonmonetary transaction within the scope of APB Opinion No. 29, Accounting for Nonmonetary Transactions. The issue also provided guidance on circumstances under which nonmonetary exchanges of inventory within the same line of business should be recognized at fair value. EITF 04-13 will be effective for transactions completed in reporting periods beginning after March 15, 2006. The Company is evaluating the impact that this issue will have on our consolidated financial statements.

 

In November 2005, the FASB issued FSP FAS 123(R)-3, Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards (“FSP 123(R)-3”). FSP 123(R)-3 provides an elective alternative method that establishes a computational component to arrive at the beginning balance of the accumulated paid-in

 

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Table of Contents

HEXION SPECIALTY CHEMICALS, INC.

 

Notes to Consolidated Financial Statements—(Continued)

(In millions, except share and per share data)

 

capital pool related to employee compensation and a simplified method to determine the subsequent impact on the accumulated paid-in capital pool of employee awards that are fully vested and outstanding upon the adoption of SFAS No. 123(R). We are currently evaluating this transition method.

 

3. Business Acquisitions

 

2004 Acquisition of Resolution Specialty

 

On August 2, 2004 (the closing date) Resolution Specialty, as assignee of Resolution Specialty Inc., purchased the Specialty Resins and Monomers and Ink businesses of Eastman Chemical Company (“Eastman”) for $192, including direct acquisition costs (“Resolution Specialty Transaction”).

 

The Resolution Specialty Transaction has been accounted for under the purchase method of accounting. The cost of the Resolution Specialty Transaction was allocated to the assets acquired and liabilities assumed based on estimates of their respective fair values at the date of acquisition. Fair values were determined based upon appraisals and internal studies. As the fair value of net assets acquired exceeded cost, no goodwill was recorded in the transaction.

 

In connection with the Resolution Specialty Transaction, Resolution Specialty Inc. executed a Senior Subordinated Note Purchase Agreement (“Seller Note Financing”) with Eastman on August 2, 2004, which provided for the sale of $50 aggregate principal amount of Senior Subordinated Notes of Resolution Specialty Inc. to Eastman that are due and payable in 2011. Such notes were delivered to Eastman as partial consideration of the Resolution Specialty Transaction. These notes were subsequently repaid on May 31, 2005 when the Company entered a senior secured credit facility. See Note 8.

 

The following table summarizes the assets acquired and liabilities assumed at the date of acquisition of Resolution Specialty.

 

    

Fair Value at

August 1, 2004


Current assets

   $ 196

Property, plant and equipment

     87

Other assets

     1

Intangible assets

     —  

Goodwill

     —  
    

Total assets acquired

     284

Current liabilities

     80

Long-term debt

     3

Other liabilities

     9
    

Total liabilities assumed

     92
    

Net assets acquired

   $ 192
    

 

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Table of Contents

HEXION SPECIALTY CHEMICALS, INC.

 

Notes to Consolidated Financial Statements—(Continued)

(In millions, except share and per share data)

 

2004 Acquisition of Borden Chemical by Apollo

 

On August 12, 2004, BHI Investment LLC, an affiliate of Apollo, acquired all of the outstanding capital stock of Borden Holdings, Inc. (“BHI”), Borden Chemical’s parent at that time, for total consideration of approximately $1.2 billion, including assumption of debt.

 

The acquisition of BHI, and the payment of transaction fees and expenses, was financed with the net proceeds of a $475 second-priority senior secured private debt offering (the “Second Priority Notes”) by two newly formed, wholly owned subsidiaries of Borden Chemical and certain equity contributions to BHI Acquisition from Apollo. Collectively, these transactions are referred to as the “Borden Transaction.”

 

2005 Acquisition of Bakelite

 

On April 29, 2005, Hexion Specialty Chemicals Canada, Inc., a subsidiary of Hexion, through its wholly owned subsidiary, National Borden Chemical Germany GmbH, completed its acquisition of Bakelite pursuant to a share purchase agreement with RÜTGERS AG and RÜTGERS Bakelite Projekt GmbH (collectively, the “Sellers”) dated October 6, 2004 (the “Bakelite Acquisition”) for a net purchase price of approximately €206, or approximately $266, subject to certain adjustments. The Company incurred direct costs associated with the acquisition of $42, which have been capitalized as part of the purchase in accordance with SFAS 141 and are included in the net purchase price. Based in Iserlohn-Letmathe, Germany, Bakelite is a producer of phenolic and epoxy thermosetting resins and molding compounds with 13 manufacturing facilities and 1,700 employees, primarily in Europe and Asia. The acquisition provided the Company with additional phenolic resin technology and products and a new epoxy resin technology platform.

 

The Company financed the Bakelite Acquisition through a combination of available cash and a second-priority senior secured bridge loan facility in the amount of $250. The bridge financing arrangement had a variable interest rate equal to LIBOR plus an applicable margin and had a final maturity date of July 15, 2014. The bridge financing arrangement was settled and cancelled on May 31, 2005 using proceeds from the $150 Second-priority senior secured floating rate notes due 2010 and $100 of term loan debt borrowed under the Company’s credit facility (See Note 8). The Bakelite Acquisition has been accounted for under the purchase method of accounting. As such, Bakelite’s results of operations are included in the Company’s Consolidated Financial Statements (the “Financial Statements”) from the date of acquisition.

 

On December 14, 2004, in order to mitigate the risk of foreign currency exposure related to the Bakelite Acquisition, the Company entered into a foreign currency forward position of $235 to purchase Euros with U.S. Dollars at a rate of 1.3430, contingent upon the close of the transaction. On March 31, 2005, the Company adjusted the contract to have a target settlement date of April 29, 2005 and a new exchange rate of 1.3446. In conjunction with the consummation of the Bakelite Acquisition, the Company realized an aggregate loss of approximately $9 on this contract, the current year portion of which is included as Other non-operating expense in the Consolidated Statement of Operations.

 

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HEXION SPECIALTY CHEMICALS, INC.

 

Notes to Consolidated Financial Statements—(Continued)

(In millions, except share and per share data)

 

The following table summarizes the fair values of the assets acquired and liabilities assumed at the date of acquisition. Fair values are based upon appraisals, internal studies, and analyses and are subject to final adjustments.

 

    

Fair value at

April 29, 2005


Current assets

   $ 290

Property, plant and equipment

     166

Other assets

     4

Intangible assets

     72

Goodwill

     63
    

Total assets acquired

     595
    

Current liabilities

     172

Long-term debt

     21

Other liabilities

     136
    

Total liabilities assumed

     329
    

Net assets acquired

   $ 266
    

 

Of the $72 of acquired intangible assets, $19 was assigned to tradenames, $16 was assigned to technology and $37 was assigned to customer relationships. The acquired intangible assets have a weighted average useful life of approximately 18 years. The tradenames have a 30-year useful life, technology has a 13-year useful life and customer relationships have a 14-year weighted average useful life.

 

Of the $63 of goodwill, $42 was assigned to the Epoxy and Phenolic Resins segment and $21 was assigned to the Formaldehyde and Forest Products segment. No goodwill is expected to be deductible for tax purposes.

 

The Company plans several actions to enhance the profitability of Bakelite including completion of headcount reductions previously initiated by Bakelite. These actions include headcount reductions, primarily in Germany, Italy and Spain, and the closure of two facilities. The Company anticipates the headcount reductions and plant closures will be complete by 2007. Expenditures related to these actions will be substantially complete by 2009. The purchase price allocation includes a liability of $23 reflecting the estimated cost of the activities (principally related to headcount reductions). This liability at December 31, 2005 is $19, reflecting severance payments of $2 and a related foreign currency translation of $2.

 

2005 Acquisition of Resolution Performance and Resolution Specialty Minority Interests

 

Upon the Combinations, shares of Resolution Performance Inc., the former parent of Resolution Performance, and Resolution Specialty Inc. held by minority shareholders and management were exchanged for shares in Hexion LLC. The minority shareholders and management held ownership interests of 28.2% and 5% for Resolution Performance and Resolution Specialty, respectively, on a fully diluted basis. The acquisition of these ownership interests was accounted for under the purchase method of accounting and pushed-down to the respective acquired businesses.

 

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HEXION SPECIALTY CHEMICALS, INC.

 

Notes to Consolidated Financial Statements—(Continued)

(In millions, except share and per share data)

 

The following table summarizes the step-up to fair value of the assets acquired and liabilities assumed at the date of acquisition based upon the percentage ownership acquired from the minority shareholders. Fair values are based upon preliminary third party appraisals and internal studies and are subject to final adjustments.

 

    

Incremental

fair value at

May 31, 2005


Current assets

   $ 9

Property, plant and equipment

     26

Intangible assets

     20

Goodwill

     56

Other assets

     11
    

Total asset step-up

     122

Current liabilities

     3

Long-term debt

     8

Other liabilities

     21
    

Total liability step-up

     32
    

Net assets stepped-up

   $ 90
    

 

As a result of the exchange of minority interest shares, Shareholders’ Deficit was adjusted by $127, consisting of the $90 step-up to fair value of net assets and a $37 reclassification from minority interest to Paid-in capital. Additionally, $5 and $11 of Accumulated other comprehensive income and Accumulated deficit were reclassified to Paid-in capital to recognize an accumulated negative basis by minority interest holders whose shares were exchanged.

 

Of the $20 of acquired intangible assets, approximately $17 was assigned to patents and $3 was assigned to tradenames. The acquired intangible assets have a weighted average useful life of 17 years.

 

Of the $56 of goodwill, $7 was assigned to the Coatings & Inks segment, and $49 was assigned to the Epoxy and Phenolic Resins segment. No goodwill is expected to be deductible for tax purposes.

 

The following unaudited pro forma financial information combines the consolidated results of operations as if the Bakelite Acquisition and the combination of Resolution Performance, Resolution Specialty Inc. and Borden Chemical had occurred as of the beginning of the periods presented. Pro forma adjustments include only the effects of events directly attributable to the acquisitions. The pro forma adjustments reflected in the tables below include amortization of intangibles, depreciation adjustments due to the write-up of property, plant and equipment to estimated fair market value, and interest expense on the acquisition debt for the Bakelite Acquisition and related income tax effects.

 

     2005

    2004

 

Net sales

   $ 4,717     $ 4,105  

Loss from continuing operations

     (86 )     (357 )

Net loss

     (95 )     (357 )

Basic and Diluted Share Data

                

Loss from continuing operations

   $ (1.04 )   $ (4.32 )

Net loss

     (1.15 )     (4.32 )

 

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HEXION SPECIALTY CHEMICALS, INC.

 

Notes to Consolidated Financial Statements—(Continued)

(In millions, except share and per share data)

 

The following are included in the pro forma Loss from continuing operations:

 

     2005

   2004

Payment to Apollo to cancel fee agreements

   $ 11    $ —  

Cost of sales related to inventory sold that was stepped-up at the acquisition date

     16      9
    

  

     $ 27    $ 9
    

  

 

The pro forma financial information does not necessarily reflect the operating results that would have occurred had the acquisitions been consummated as of the beginning of the periods presented, nor is such information indicative of future operating results.

 

4. Discontinued Operations

 

In 1998, pursuant to a merger and recapitalization transaction sponsored by The Blackstone Group (“Blackstone”) and financing arranged by The Chase Manhattan Bank (“Chase”), Borden Decorative Products Holdings, Inc. (“BDPH”), a wholly owned subsidiary of the Company, was acquired by Blackstone, which subsequently merged with Imperial Wallcoverings to create Imperial Home Décor Group (“IHDG”). The Company received approximately $309 in cash and 11% of IHDG common stock for its interest in BDPH. On January 5, 2000, IHDG filed for reorganization under Chapter 11 of the U.S. Bankruptcy Code. IHDG emerged from bankruptcy in April 2001. The IHDG Litigation Trust (the “Trust”) was created pursuant to the plan of reorganization in the IHDG bankruptcy to pursue preference and other avoidance claims on behalf of the unsecured creditors of IHDG. In November 2001, the Trust filed a lawsuit against the Company and certain of its affiliates seeking to have the IHDG transaction voided as a fraudulent conveyance and asking for a judgment to be entered against the Company for $314 plus interest, costs and attorney fees. On June 8, 2005, the Company reached an agreement with the parties to settle and release all claims against the Company for $15. This amount was subsequently paid by the Company in July 2005. As the settlement directly related to a divested business which was accounted for as a discontinued operation in 1997, the Company has included the settlement cost in Loss from discontinued operations in its Financial Statements.

 

In 1996 and 1997, the Company sold its Dairy and Foods businesses. Both disposals were accounted for as discontinued operations in those years. In 2005, the Company received $6 as settlement from a class action suit related to raw material purchases by the divested businesses between July 21, 1991 and June 30, 1995. As the settlement directly related to the previously divested businesses, the Company has included the settlement proceeds in Loss from discontinued operations in its Financial Statements.

 

Typically, losses from discontinued operations are recorded in the Financial Statements net of tax; however, because the Company has a full valuation allowance on its domestic deferred tax assets and is unable to realize an income tax benefit from these losses, the corresponding benefit has been offset by a full valuation allowance.

 

5. Related Party Transactions

 

Administrative Service, Management and Consulting Arrangements

 

In connection with their respective acquisitions by Apollo, Resolution Performance, Resolution Specialty and Borden Chemical entered into certain management, consulting and transaction fee agreements with Apollo and its affiliates for the provision of certain structuring and advisory services. These agreements allowed Apollo and its affiliates to provide certain advisory services to the companies for terms up to ten years. The companies also agreed to indemnify Apollo and its affiliates and their directors, officers and representatives for potential

 

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HEXION SPECIALTY CHEMICALS, INC.

 

Notes to Consolidated Financial Statements—(Continued)

(In millions, except share and per share data)

 

losses relating to the services contemplated under these agreements. In addition, upon the closing of the Resolution Specialty and Borden Chemical transactions in the third quarter of 2004, the Company paid $12 for transaction and advisory services, and reimbursed expenses of $1. Prior to the Combinations, on May 31, 2005, Resolution Performance and Resolution Specialty terminated their agreements with Apollo, thereby releasing any and all obligations and liabilities by all parties under the respective agreements. In consideration of the terminations, Resolution Performance and Resolution Specialty paid Apollo $4 and $7, respectively. These amounts are included within Transaction related costs in the Company’s Consolidated Statements of Operations.

 

At the time of the Combinations, the Company entered into a seven-year, amended and restated version of the former Borden Chemical management consulting agreement with Apollo (the “Amended Management Consulting Agreement”). The terms of the Amended Management Consulting Agreement currently provide for annual fees of approximately $3 and provide for a lump-sum settlement equal to the net present value of the remaining annual management fees payable under the remaining term of the agreement in connection with a sale of the Company or an IPO.

 

Pursuant to the agreements in effect during the years ended December 31, 2005, 2004 and 2003, the Company paid fees of $4, $2 and $0, respectively. The 2003 management fee of less than $1 was paid in 2005. These amounts are included within Other operating expense in the Company’s Consolidated Statements of Operations. There were no amounts payable to Apollo at December 31, 2005 or 2004.

 

In connection with the Bakelite Acquisition, in exchange for deal structuring and negotiating provided by Apollo, the Company made payments to Apollo in the amount of $4. These amounts are considered direct costs of the acquisition and have been capitalized as part of the purchase.

 

Other Transactions and Arrangements

 

The Company sells finished goods to an unconsolidated joint venture of the Company and certain Apollo affiliates. These sales totaled $25, $11 and $15 for the years ended December 31, 2005, 2004 and 2003, respectively. Accounts receivable from these affiliates were $2 and $1 at December 31, 2005 and 2004, respectively. The Company also purchases raw materials and services from certain Apollo affiliates. These purchases totaled $12, $12 and $5 for the years ended December 31, 2005, 2004 and 2003. The Company had accounts payable to Apollo affiliates of less than $1 at December 31, 2005 and 2004 related to these purchases.

 

Upon closing the Borden Transaction, in 2004 Borden Chemical paid transaction-related costs of $9 on behalf of BHI Investment LLC, $22 on behalf of BW Holdings, LLC and shared deal incentive costs of $14. These amounts are included within Transaction related costs.

 

Financing and Investing Arrangements

 

In November 2000, Resolution Performance provided loans to certain officers of Resolution Performance totaling $1 to purchase stock of Resolution Performance, Inc.

 

6. Goodwill and Intangible Assets

 

At December 31, 2005 and 2004, the Company’s management performed the annual goodwill impairment test. As required by SFAS No. 142, “Goodwill and Other Intangible Assets,” the Company identified the assets (including goodwill) and liabilities of the reporting units. The

 

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HEXION SPECIALTY CHEMICALS, INC.

 

Notes to Consolidated Financial Statements—(Continued)

(In millions, except share and per share data)

 

Company determined estimated fair values of the reporting units to assess whether the estimated fair value of each reporting unit was less than the carrying amount of the units net assets.

 

Fair values were determined using a standard methodology based upon comparing certain operating metrics of the entity to those of a set of comparable companies in the same industry. Using this method, market multiples and ratios based on operating, financial and stock market performance are compared across different companies and to the entity being valued. The Company employed a comparable analysis technique commonly used in the investment banking and private equity industries to estimate the values of its reporting units based on the EBITDA (earnings before interest, taxes, depreciation and amortization) multiple technique. Under this technique, estimated values are the result of an EBITDA multiple derived from this process applied to an appropriate historical EBITDA amount. At December 31, 2005 and 2004, the fair value of each reporting unit exceeded the carrying amount of assets and liabilities assigned to the units.

 

The changes in the carrying amount of goodwill by segment for the years ended December 31, 2005 and 2004 are as follows:

 

     Epoxy and
Phenolic
Resins


    Formaldehyde
and Forest
Products


    Performance
Products


   Coatings
and Inks


   Total

 

Goodwill balance at December 31, 2003

   $ —       $ —       $ —      $ —      $ —    

Acquisitions

     4       23       23      —        50  

Foreign currency translation

     —         —         1      —        1  
    


 


 

  

  


Goodwill balance at December 31, 2004

   $ 4     $ 23     $ 24    $ —      $ 51  

Acquisitions

     95       21       —        7      123  

Foreign currency translation

     (4 )     (1 )     —        —        (5 )
    


 


 

  

  


Goodwill balance at December 31, 2005

   $ 95     $ 43     $ 24    $ 7    $ 169  
    


 


 

  

  


 

The Company’s intangible assets with identifiable useful lives consist of the following:

 

     At December 31, 2005

   At December 31, 2004

     Gross
Carrying
Amount


   Accumulated
Amortization


   Net
Book
Value


   Gross
Carrying
Amount


   Accumulated
Amortization


   Net
Book
Value


Intangible assets:

                                         

Formulae and technology

   $ 114    $ 27    $ 87    $ 82    $ 20    $ 62

Customer lists and contracts

     55      12      43      20      7      13

Other

     33      2      31      2      1      1